Freddy Garcia on Roth Conversion and Fast Growth

Welcome to Left Brain Thinking, where creative investment ideas meet logical analysis. That's the hallmark of Left Brain Investment Research, where the analysts are looking for growth companies with the potential to double in 2 to 3 years and high-yield bonds with the potential for dramatic price appreciation. Today we're talking about how all of that growth can impact your decision to convert your individual, uh, retirement accounts to a Roth IRA. And we're having that discussion with Freddie Garcia, Vice President of Investments for Left Brain Wealth Management. Freddie, welcome back to Left Brain Thinking.

Chuck, thanks for having me. It's always a pleasure to come on your show.

So it is the time of year when people are trying to figure out what they want to do in terms of Roth conversions, which is where you take your traditional IRA or maybe your self-directed IRA, whatever kind of IRA you have. And you say, I'm going to pay taxes now so that I don't have to pay taxes later. Nobody loves accelerating taxes, but in your case, what you look for at Left Brain is always accelerated growth. So there's that trade-off and that impacts the decision, doesn't it?

Chuck, it sure does. And one of the reasons I wanted to talk about this topic today is usually we come on the show, me or my colleagues, and anyone from Left Brain, and we cover specific securities and talk about their great growth potential. As an advisor, one of the things I always recommend is now that you have this information, what do you do with it? And taking the information and using some of the stocks that we've covered in some of the past shows and actually using it in your Roth conversion can be very beneficial. And the Roth conversion— this isn't anything new. This, this has been around for quite a while. The Roth itself goes back over 20 years, and the income cap was removed about 10 years ago as far as now anyone can convert. I've never been a big fan of it myself, just because I feel people have not done it properly. And that's why I wanted to come on today and talk about how do you make sure you take advantage of that benefit of converting and getting that after-tax growth.

And let's make it clear. What you have not been in favor of has been the Roth conversion, not the Roth itself. You're happy with the Roth IRA. It's been that decision where I'm I'll accelerate taxes, pay my taxes now so that it's tax-free later. The problem is not the Roth, it's the conversion. And then the secondary side of that is you're in favor of it if it's done the right way. Right?

That's correct, Chuck. A lot of times when you hear other advisors or you turn on any financial show and everyone early in the year talks about the Roth conversion, but what they miss the boat on is talking about how to really get the best benefit out of it. And for example, the reason why I haven't been in favor of it when people do it incorrectly is if we actually look back and look at what people actually— their rate of return is. So using a Dalbar study, and we go back 30 years, the average investor's return is only about 4.1%. The S&P during that time frame has done about 10%. Okay? So that means that average investors aren't even getting even half —of what the average has been. This is important because when we actually look at the conversion, what happens when you take money— say, for example, if somebody's converting $100,000 in one year, and they're doing it early in the year, and they're at a 30% tax rate— that means they're going to lose about 30% of their initial amount in the conversion. So they have to overcome that hurdle right away. And if they only are averaging about a 4.1% return, well, that's going to take close to about 8 to 9 years just to get back to even with that amount. And that's just breaking even, getting back to their original $100,000 over an 8-year timeframe. So that's a lost opportunity because you could have had money invested during that timeframe, during that 8 years, and been, you know, at a much higher rate. So that's the reason why I've cautioned people before about the conversion, because if you're not investing properly, the tool and the mechanism isn't going to be very beneficial to you.

What we're also saying is that it kind of depends on the assets you're converting. I mean, if somebody is saying, hey, I want to make a conversion, but I'm doing it with bond funds that are not generating super yields or what have you, you'd say stick where you're at. Whereas if they're going to convert and say, this is the money I would be investing the left-brain way, well, then it's growth giving you what you need, right?

Yeah, that's exactly right. So if we put the left-brain spin on it and we're not looking at a 4.1% return or even an index return of 10% where it can take— again, I told you with the 4.1%, it takes about 8 years just to break even. If you're doing 10%, well, it would take less than half of that. But what about if you looked at some of the stocks we've talked about? And earlier in the year, I was on here right in the beginning of January, and I talked about 2 stocks in particular, Square and PayPal. Square is up about 27% year to date. PayPal is up about 20— 2 to 25% year-to-date. Now, if someone had looked at stocks like that and used that as part of their conversion, they're going to have a lot more benefit in the end because just possibly within the year they can be back to even, and especially if they do it early on in the year. And if they keep using stocks that have the potential to double in 2 to 3 years, they can maximize their gain very quickly and really take advantage of that tax-free growth. And that's what the big benefit is of the Roth conversion, is tax-free growth. But many investors struggle because they never get to that point because they're just initially taking a long time just to get to even. So the left-brain thinking is not just getting to even, but really maximizing the growth. And it's something I did for myself early in this year is where I converted because I knew I took money and I wanted to get the remaining tax-free growth throughout this year. Because when I do pay taxes on it, it is next year, but I won't pay taxes on the growth. It'll just be that initial conversion. So hopefully that Roth is worth a lot more later than it was when I initially converted it. Yeah.

So what we're saying is this is a little bit about timing, not that it wouldn't be sensible to do it later on in the year, but if you convert now, you get the benefit of having it happen now and you don't have to pay the taxes on the conversion until next year. And then the other side is this is more about asset location than asset allocation. This is if you have assets that would benefit from the big growth relatively quickly, this is where you want to put them.

That's exactly right, because you want that tax-free growth. And remember, in a Roth, it's a little different than your traditional IRA in the fact that with your traditional IRA, you will have an eventual required minimum distribution. You don't have that with a Roth. So if you feel that, well, I'm going to take more risk if I just pick, say, a couple of the stocks, say, from even our chosen list. If you're just picking a couple of stocks from that list, you might feel, well, then I'm taking more risk. Well, keep in mind, your timeframe for a Roth should be a lot longer because one, you need 5 years anyway to get the tax-free benefit. It has to be in there. That's one of the requirements. And then secondly, there is no required minimum distribution on it. So you're never required to take money out of the Roth.

And of course, even if you wind up passing it on to your heirs and they would face a required minimum distribution on an inherited Roth, it is still coming out tax-free. So it's not the worst thing in the world, and you will have gotten your benefits out of it. Correct. Freddie, anything else people should be considering about a Roth? Because a lot of times they're run through formulas, and as you point out, you haven't liked the formulas because it's really been about the investing style. But is there more that you would want people to make sure of before they make this change?

Yeah, definitely. When you're considering the Roth, you always want to consult with your tax consultant first, because with the Roth, whatever money you use, it can throw you into a different tax bracket. So when you're trying to figure out the amount you're going to lose, you want to make sure you figure that amount in. Also too, if you have the benefit of paying for the tax amount out of an after-tax account, that way if we go back to that same example, if you have $100,000, you can have that whole $100,000 convert and then you pay for the taxes on your own. The other method is where the taxes get subtracted from that $100,000, but then you only have, say for example, if you're in the 30% tax rate, $70,000 growing. So the better way to do it, if you have the capital available is to pay the taxes outside of the conversion. Freddie, great stuff as always.

Thanks so much for joining me on Left Brain Thinking.

Well, Chuck, thanks so much for having me.

Left Brain Thinking is a joint production of Left Brain Investment Research and MoneyLife with Chuck Jaffe. Our conversations are not personalized investment recommendations but are designed to engage your brain. Please do your diligence before making any financial transaction. I'm your host, Chuck Jaffe. You can learn more about my weekday podcast at moneylifeshow.com. Thanks to my guest, Freddy Garcia, Vice President of Investments for Left Brain Wealth Management. Learn more about the firm and its services at leftbrainir.com, and they're on Twitter @LeftBrainIR. Left Brain Thinking is available every Wednesday. Find it and subscribe on your favorite podcast app and tell your friends about it, and plan to put your left brain thinking cap on every week. Until next week, stay safe, everybody.