Wealthy After Divorce

S2EP13: Transforming Finances: The Role of Roth Conversions After Divorce with Melissa Joy

• Melissa Fradenburg, CDFA® and Jacki Roessler, CDFA® • Season 1

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Are you curious about how your financial landscape changes after divorce? Join us as Co-Host Melissa Fradenburg and Pearl Planning founder, Melissa Joy, CFP®, CDFA® talk Roth conversions after divorce.  In this episode,  Melissa discusses how a move to a lower tax bracket following a divorce can open up opportunities for financial growth. Melissa shares her insights on how to maximize the financial benefits from spousal support payments and reduce tax liabilities. Tune in to learn about the resources and events that can aid you in crafting a long-term financial strategy tailored to your new reality.

Resources:

Links are being provided for information purposes only. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Pearl Planning cannot guarantee that the information herein is accurate, complete, or timely. Pearl Planning makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. Pearl Planning financial advisors do not render advice on tax matters. You should discuss any tax matters with the appropriate professional.

Speaker 1:

Welcome to the Wealthy After Divorce podcast. Jackie Ressler, a divorce financial planner with almost 25 years experience, and myself, melissa Freidenberg, financial advisor with Pearl Planning. We are both certified divorce financial analysts and your co-hosts. If you're thinking about divorce or in the process of divorce, this is a time for you to take a deep breath and give yourself permission to gain clarity on the financial decision they're facing. While the term wealth typically refers to money and possessions, we know that truly being wealthy means a whole lot more. Together with our guests on this podcast, we will help you live wealthy after divorce.

Speaker 1:

Hello and welcome to the Wealthy After Divorce podcast. This is Melissa Freidenberg, and today our guest is Melissa Joy, who is the founder and president of Pearl Planning, which Pearl Planning in case you're a newer listener is where Jackie and I are financial advisors, and we are so honored to have Melissa as our guest today because not only is she a certified financial planner, she also has her certified divorce financial analyst designation, and Melissa and I co-host a podcast together called Women's Money Wisdom, and she is going to talk about a very important topic for recent divorcees, which is Roth Conversion. So, melissa, welcome to the podcast.

Speaker 2:

Hi, melissa, I'm so glad to be here. I love the Wealthy After Divorce podcast. I've learned so much from it and I'm excited to be a guest.

Speaker 1:

Before we get into what a Roth Conversion is, could you briefly explain to our listeners just the difference between a Roth IRA and a traditional IRA, in case they aren't familiar?

Speaker 2:

Yes. So a traditional IRA is kind of works like traditional company retirement plans like 401ks or 403Bs you put money in and if you're under a certain income range you get the opportunity to get tax deferrals. So what that means is you don't report that amount that you put in on your taxes as income and pay tax when you take the money out at an ordinary income tax rate. And a Roth IRA is the opposite. In fact, you do report your income now, even for the money that you put into the account, and then when you take the money out it's tax free and all the growth is tax free.

Speaker 2:

We often refer to that as a tax exempt investment versus a tax deferred investment, and so we're getting a little geeky here. We're getting into taxes. We're going to walk you through some of it as we go through the episode. But rule of thumb is if you're in a lower tax bracket today, then you will be in the future. Then you may want to consider a Roth contribution, and if you're in a higher tax bracket today, then you think you will be over time, then it may be better to consider a traditional IRA contribution. Or if you just can't afford the taxes but do have some money that you'd be able to save.

Speaker 1:

Okay, and that brings us to kind of our topic today of why it makes sense for a lot of divorcees to consider Roth, because Oftentimes you may find yourself in a lower tax bracket after a divorce right.

Speaker 2:

So right, there's no rule of thumb not everyone. Some people will be in a much higher tax bracket. So if you're a high earner and you had a spouse that was a lower earner or equal, then your individual tax bracket may be higher. So this isn't for everyone, but I think it's informative and informational for you because also, when people get divorced, they kind of develop their divorce community and kind of talk amongst friends. All advice is personalized, so don't always use the rules of thumb that we're talking about here.

Speaker 2:

The first thing you want to know is what are my tax rates now? And in many cases, you might want to compare them to what your tax rates were before. This time of year in 2023,. I've been working with a lot of clients that do have received a lot of assets in their divorce and perhaps they're retired or they are in a very low rate, going to be in a lower tax bracket. Perhaps they don't work. Also, perhaps they're receiving spousal support, and spousal support for more recent divorces is not taxable. There's a dividing line. If you were divorced earlier, then that may be taxable, but you could get $100,000 a year or $200,000 a year in spousal support and not have to pay any income tax on that. So that's a play in this discussion.

Speaker 1:

Absolutely, and then that would not count towards income limits for Roth contributions either, correct?

Speaker 2:

That's right, Although you do need to earn income in order to make those contributions. So if you're just not working at all, you're not reporting any earned income. If you had an IRA distribution or conversion, that doesn't count then you're not going to be making a contribution. But let's say that you have a part-time job. You're going to report $10,000 of income, but you also have $100,000 of spousal support. Well, to the IRS you would be reporting that $10,000 of income and the spousal support would. If it were subject to the newer rules where spousal support is not taxable, that money would be earned or received tax-free, and so you could make a contribution to Roth or traditional IRA in that particular very basic case, because everyone gets a standard deduction that $10,000 actually isn't taxable at all. So I couldn't think of a reason why you wouldn't want to do a Roth contribution instead, just because you're at a 0% tax rate.

Speaker 1:

And let's just before we get into why this makes sense, the term Roth conversion. If you could explain what that means, in case our listeners are unfamiliar.

Speaker 2:

Well, we're adding to the layers of complexity. But for the first IRAs out there were traditional, and then the Roth IRAs were added on and then there was a pathway called a conversion, where you can convert or change money from a traditional account to a Roth account. So to keep it super simple, let's say you'd been putting money in over the years and you had I'm just going to pick up easy round, number $10,000 in an IRA and you'd gotten tax deductions all along the way for putting that money in. So that's called that's tax deferred. That's all tax deferred money. There's a little asterisk there because there could potentially be what's called after tax money there, but we'll talk about that in a second.

Speaker 2:

So let's say that you tell the financial institution that has that IRA hey, I would like that to turn into a Roth account. The mechanics of it are that you need a Roth IRA account open Maybe you already have one or maybe you open a new one and then you fill out a form called a conversion form and with that conversion in that tax year there would be a report that says, hey, this money that was tax deferred turned into a Roth tax exempt. And just like when you take money out of an IRA. When you retire and you pay taxes as ordinary income, that $10,000 would be converted over and it would be reported as an income event. So that is what a conversion is. It turns traditional assets into Roth and then you have a tax report, but in some cases your taxes associated with that conversion could be very low, and those are some of the examples that we're running into.

Speaker 1:

So if you've gone through a divorce and you're in a lower tax bracket now, this is definitely something you would want to look into.

Speaker 2:

Right. So let's take an extreme example. Somebody is in a high net worth divorce. They have divided up millions of dollars of investment, retirement accounts, real estate, etc. Perhaps they have half a million in a traditional IRA, or they received through a Quadro 401k. That is traditional, so that tax defer 401k's work is similarly to IRAs. And let's say that for five years they're going to receive $100,000 of spousal support and then after that they may need to rely on their retirement accounts to supplement their income sources. Perhaps it's a great divorce. The person is in their early 60s. They haven't turned on social security yet.

Speaker 2:

In that case, if those were the only facts out there, if there were no other tax headwinds, nothing else was going on. There's a portion of their IRA that half a million dollar account that could be converted with no tax costs for an amount equal to their deduction. And then the way tax brackets work is you fill up one before you go to the next. So, for example, if somebody's in the 24% tax bracket as an individual, which is income above $89,076, in 2023, they would first fill up the 10% bucket, which is zero to $10,275, after you get through the itemized or the standard deduction. Then they would fill up the 12% bucket $10,000 to I'm rounding, but to $41,000. Then they would fill up the 22% bucket, which is really small, or which is $41,000 to $89,000. And then they're at 24% and so their average taxes are blended. If they don't pay 24% in taxes, they pay a lower amount which because of these other buckets.

Speaker 1:

They're the weeds there, Sorry, no, that is so important to explain and I think you know so often it's. What I love about our podcast is because we really try to break it down for people. If you don't understand the tax brackets and how they work, you are not alone.

Speaker 1:

I can across this all the time and I'm so grateful that you explained that because I think it's so important you know to, when you're considering something that could, you know, bump up your tax bracket, that it's important to understand that concept, that you know the amount that you convert you would be paying ordinary income taxes on in that year. So it is important to understand that.

Speaker 2:

Absolutely. It's so important to understand that fortunately, there's help if you work with a tax professional CPA or enrolled agent to file your taxes. I mean, that's often the first thing on the list that people should get lined up for their next tax return, because the tax preparer may have been somebody that was kind of their spouse hired or they may not have been as engaged in these types of things. So we always love to coordinate with tax people. We're not tax people ourselves, but we know enough to be dangerous Consult your CPA before doing any of these things we are talking about.

Speaker 1:

But also if somebody is listening and they want to talk about their individual situation, we'd be happy to help as well. And maybe specifically if you could touch on how working with a certified financial planner can assist you in navigating whether Roth conversion makes sense for you.

Speaker 2:

Yeah, I'm going to continue with that example so a lot of times. So there's several people I started working with this year. They're coming in with these exact circumstances. They're going to have very low reportable income and it sounds funny because I'm sure you feel like you just won the lottery when you have enough money but you get your tax return and it says you owe zero dollars. But in a financial planner's heart it kind of breaks because there's likely in cases where you have assets and opportunity to kind of free money in a very low tax bracket by turning money from traditional to Roth. And so I'm just going to continue to use that example. So when I'm working with someone, we start working with each other.

Speaker 2:

Earlier in the year I explained to them that, hey, this is going to be the first year that you're filing taxes as an individual, because once you're divorced, you guys aren't. You and your ex-spouse are not going to be filing taxes together again. There may be some stipulations in your divorce decree about who receives what income or what happened during the year, but there's straightforward information to forecast most of your tax obligations in many cases. And so we would look through and say, hey, you have some taxable investment accounts. Whenever we invest for people in taxable accounts it's like your traditional brokerage account. That's not an IRA or Roth or 401k, and we're always very tax aware and we keep track of the tax costs for those during the year. And I say, hey, we're going to plan to talk in November, december, because I think you may be a potential candidate for a Roth conversion at that point in time. I would also say, hey, do you have a tax preparer lined up? And if you do, I would love to reach out to them to discuss that, the potential for a conversion and see what they think.

Speaker 2:

Oftentimes, you know, they're like a tax preparer's job, a CPA's job is not easy because they are so busy. There are so many deadlines to meet. You know, unless you have someone who's really either slow or really engaged, they're not doing as much tax planning unless you really request it. So we're kind of doing that legwork to say, hey, we think there's a planning opportunity here. Can we leap your tax person in? And then we get there. You know, kind of like, yeah, like let's consider that and I'll say, great, we'll reach back out in November, december, because we should have a lot more clarity on what your potential taxes will be.

Speaker 2:

And so then we'd look at accounts again in November and December and in this past example, where I was saying that you could be in the 0% tax bracket while you had $100,000 of spousal support income and you have a half a million dollar account, a retirement account in an IRA, then I'd call the CPA and say, hey, it looks to me like in a few years, when social security is turned on and we have a required distribution starting, let's say, at age 73 or 75, there's a couple different rules there. That's a different episode. You know, it seems pretty clear to me that taxes are going to be higher in the future. Maybe they're going to be in the 24 or 22% bracket. And also you know who knows? But also there is legislation that sunsets the tax cuts and jobs act that bumps up tax brackets just a little bit too. That sunsets in 2025.

Speaker 2:

And so what would you think, cpa, about filling up either the 10 or 12% bucket, which could put as between 20 and 50,000, I'm using very round numbers into a Roth account, where you would potentially be paying less than 12% in taxes on that money that's converted and then let it grow tax-free and you don't pay taxes when you take the money out, and fortunately, both your CPA has in many cases or most they should have software that can kind of consider that and, as well, we use kind of forecasting software where we're always thinking about the tax consequences.

Speaker 2:

We could even illustrate to you hey, here's what this potential change would do for your investment accounts.

Speaker 2:

Here's the potential tax bill which, like I said, it would be potentially less than $5,000 for your entire tax obligation, because there are lower buckets to fill up, like we were describing, and then we would go and also show potentially like a forecast of how much more money you would have to spend over a lifetime or how much lower your tax rate could be because of that conversion. And we never like to just every person that walks in off the street. We're not looking to say here's how we convert everything, regardless of the tax cost, but this is a really strong and powerful way to increase your financial position in a situation where you always feel vulnerable when you've just divided your assets in half. You had a game plan for retirement and it's way different now. That weighs on people. It feels like they've lost a lot. Well, this is a way for you to feel like you're really gaining something, that if the ex-spouse is writing those checks for Spousal Support, they're actually paying those taxes. So it's a way to it's kind of a double win based on current legislation.

Speaker 1:

Absolutely. Now, you did touch on it briefly with required minimum distributions. Do you want to touch on that a little bit? As far as the advantage of the conversion, when it comes to that yes.

Speaker 2:

So at a certain point in time in life and I say a certain point, it used to be always age 70 and a half super random number, but that was the age where you had to start doing a calculation to take out a certain percent that changes over time of your retirement accounts over time. And then, ironically, this is a part of politics that everybody agrees on it's okay to change rules and when you can take money out of retirement accounts. So over the past couple of years, there's been two times that changes have been made, and the first time it moved up from age 70 and a half to age 72. And now we're in a regime where, if you haven't hit your arm de-age yet, it will either be between 73 and 75, depending. People that are older have age 73 and younger people age 75.

Speaker 2:

These are rules that really benefit people with more money, because if you don't have as much money and you do have retirement savings, oftentimes you're really using those funds to supplement your social security income. But for wealthier people, you don't have to take anything out of your traditional account until age 73 or 75 today, if you haven't already reached that RMD required minimum distribution age. For Roth accounts, though there is not a required distribution, so these are often the most desirable assets for your kids or anyone else to inherit as well as they are. You just get complete optionality about when you take the money out, because, of course, the reason or one of the reasonings for these required distributions is, eventually, the federal government wants their tax bills to be paid, and if you deferred forever, You're not required to spend the money.

Speaker 1:

you just have to take it out of the tax deferred account and pay the IRS. So there you go.

Speaker 2:

Exactly. And so you know you can radically change the amount you're required to take out in a situation where you have more money in IRAs than you need. And so, with all of this, this goes back to what is the value of a financial planner. Well, we are thinking about you today, and we, at least at our firm, we love to tell you yes for all the things you want to do, but we're also trying to protect your future self and we're also trying to give you as much money in the game of you and your heirs and Uncle Sam, we want you to have you know, we would rather reduce your tax obligations, and it's taxes over time, not taxes in any given year.

Speaker 1:

Actually along those lines. If somebody is listening and they're thinking I want to talk more about this or what other resources do you have if I need to think about my long term financial plan post divorce, could you share with listeners any you know upcoming resources or upcoming events or resources with pro planning that they may be interested in?

Speaker 2:

Yeah, so we do have an upcoming event. We have a year in financial and tax planning strategy conversation. It's a webinar, the girlplancom slash events. You can find that there and also the replay will be on our website.

Speaker 2:

You know what I think about in this whole entire conversation and the whole point of this discussion is we really want to help you know how to use your money when you get assets in a divorce. In most cases, you know that's money you need to use over time and our goal the role of a certified divorce financial analyst as well as a certified financial planner is not only to tell you what to use, because a lot of people do that yeah, you'll take a withdrawal but tell you how to do it. So that part of this is like whether it's a conversion or there's a similar like very attractive. If you just need the money and you're like I'm going to take out my money from my taxable account first, we might say whoa, whoa, whoa. You have the opportunity to take money out of very low tax bracket. If we take some money out, a portion out of your retirement account, that's just what we do.

Speaker 2:

It's like the mechanics, it's the when do you want to receive that paycheck, those types of things. So, you know, I think it's really helpful if you inform yourself and if you're working with a professional that is also informative, like I think we are, then you would be able to ask the question hey, should I think about converting something? And they may be like, no, here's why not, or yeah, let me think about that, and so hopefully you're working with a professional that you proactively thinking through and there are a lot of moving parts, so I hope that you are inspired to at least consider this as an option if you're listening to this podcast, and we will link some resources in the show notes.

Speaker 1:

And if you still have questions or you're not working with someone right now and would like to, I will link the Pearl Planning Contact in the show notes as well. So it's always an option to set up an introductory call. Melissa and I both work with post divorce clients getting their new financial picture into a financial plan, as well as helping them manage assets, if that's something that they need help with. So, melissa, thank you so much for your time today on the Wealthy After Divorce podcast. We really appreciate you and your wisdom, and thank you so much for being our guest.

Speaker 2:

Well, I love the show. Keep up the great work, Melissa.

Speaker 1:

Thank you for listening to the Wealthy After Divorce podcast. You can find more information on Melissa Friedenberg and Jackie Ressler on our website, wwwpearlplancom, as well as on our podcast website, wwwwealthyafterdivorcecom.

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Jacki Roessler, CDFA®

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Melissa Fradenburg, CDFA®️

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