The Coronavirus-induced sell off in late Q1 2020 rattled investors globally. Markets are now trading at some of the lowest levels of the past three years and many investors are seeing their retirement account balances significantly smaller. Negative headlines surround investors daily, but there may be a silver lining to this stock market correction for long-term financial planning: a smaller tax bill for Roth IRA conversions.
With tax rates historically low, 2019 tax law changes (SECURE ACT), and asset values down, many individuals stand to benefit from using Roth IRA conversions to strategically create tax-free income in retirement. The tax cost for a conversion will be less than when the market was higher just a few months ago. This article explains some basics about incorporating a Roth conversion strategy into a long-term financial plan.
What is a Roth Conversion?
A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA. The movement into the Roth IRA is treated as a taxable distribution from your traditional IRA and thus you will recognize ordinary income – as you would when you took distributions later, as required starting at age 72. Unlike traditional distributions, there is no early withdrawal penalty if you convert your traditional IRA to a Roth and you are younger than 59 ½. The advantage of the Roth IRA is that when you make withdrawals you will recognize no taxable income. The entire balance in the Roth IRA and all the compounded growth are tax free, as long as certain requirements are met. In addition, there are no required mandatory distributions (“RMDs”) from a Roth IRA, so the account can compound tax free for your entire life and can be left to heirs without any income tax consequences.
Deciding whether to convert to a Roth IRA hinges on issues such as an individual’s tax rate now versus later, how to pay the tax bill on the conversion, investment returns and future estate planning goals. Careful analysis is required as the Roth conversion will be permanent.
When is the Best Time for a Roth Conversion?
There are many variables that affect the ideal timing of a Roth conversion, but essentially a Roth conversion is maximizing the efficiency of the timing of income and the marginal tax rate on that income. The math comes down to determining if the earnings and tax-free withdrawals on a Roth IRA balance outweigh the earnings on a traditional IRA balance minus the income taxes that will have to be paid on the initial conversion and withdrawals in retirement. Although it is very difficult to predict future income tax rates, we know that today’s rates are historically quite low and there is a good possibility they could rise in the future. This is an additional factor that favors a Roth conversion in today’s environment. Other factors that favor a current Roth conversion would include:
- Value of IRA investments are hitting a low point.
- Other losses or deductions available to offset the tax due on conversion.
- No need to take distributions as part of retirement income (assuming you have sufficient other assets)
- Planning a move to retire in a state with higher state income taxes.
- Experiencing a year with low income
- Changing jobs and rolling over a 401(k) to an IRA
There may be different situations where these factors may be applicable, but the important part is realizing that a strategic analysis will need to take place. Tax rates are important, but rates of return and time horizon of investing are also important. A longer time period of multi-generational tax-free compounding is a powerful factor that must not be overlooked!
Strategic Roth Conversion: What to Consider Before Converting?
Converting a traditional IRA to a Roth IRA may be an effective long-term financial planning strategy, but it is not for everyone. Before completing a Roth conversion, consider these two important questions:
Is there cash available to pay taxes now? Federal and state income taxes must be paid on a Roth IRA conversion. Ideally, the funds to pay for the Roth conversion come from an account outside of the pre-tax IRA. Without a balance in a taxable account from which to pay the taxes on a Roth conversion, Roth conversions take a longer time to “catch up” and be effective over the long-term. A rule of thumb is that it is only recommended to complete a Roth conversion if there is cash available outside of the retirement accounts to pay for the taxes on the conversion.
What are current tax rates and expected future tax rates? An advantage of a Roth IRA is that when the money comes out, no income taxes are due, because taxes have already been paid. When withdrawing money out of traditional IRAs and retirement plans, taxes are owed at the marginal income-tax rate because the money that went into the IRA was pre-tax.
It is easy for an individual to understand their marginal tax in the current tax year. However, what a Roth conversion calls for is also estimating a tax rate in retirement. The longer until retirement, the more unknown that rate is. Completing a Roth IRA will likely make sense when there is a high confidence that future tax rates will be higher. Analyzing future sources of retirement income in conjunction with assumptions of future tax rates is important in determining the best strategy. A detailed cash flow analysis is required to put all the pieces together and allows different assumptions to be tested in order to confidently make the decision to convert or not.
Running the Numbers: An Example of a Strategic Roth Conversion
There are many different scenarios that may be favorable for a Roth conversion. Below is an example of a common scenario with some simplified math to show the power of a properly executed Roth conversion strategy.
John is 60 years old and retired last tax year to Florida. He has a $1m IRA and $2m taxable portfolio. He and his wife expect to receive $200,000 annually from pensions beginning at age 65 that will cover most of their expenses. They also plan on receiving $55,000 in Social Security payments beginning at age 70. John wants to pass assets to his daughter who recently graduated medical school and is expected to have a high income throughout her career.
A strategy for John is to begin converting his IRA aggressively now, before his pension starts, when his only other income is dividends and interest from his portfolio (about $40,000 annually). John has a window of 5 years before receiving his pension and 12 years before he is required to take RMDs. For the first 5 years he should aggressively convert part of his IRA each year to pay taxes in the 22% or 24% tax bracket. After starting the pension, he could continue converting, but should not exceed $321,450 of income between conversions, pensions, and investments as that would push him into a higher tax bracket (based on 2020 tax rates).
If he did not convert at these rates, he would likely pay close to 35% in taxes when withdrawing RMDs at age 72 as he would be receiving a pension, Social Security, and other portfolio income. Thus, he has taken advantage of lower tax rates now to build great long-term wealth. Other advantages include passing the Roth IRA to his daughter where she may continue to enjoy tax free growth for 10 years after John passes away.
Several Key Technical Aspects of a Roth Conversion
There are several technical details to understand about a Roth conversion in order to avoid surprise tax bills. The following section outlines some tax rules to consider.
Roth conversions can no longer be undone – The 2017 Tax Cut and Jobs Act eliminated a tax law that allowed investors to undo their Roth conversion decision. This was known as a recharacterization and investors used this law to undo Roth conversions on investments that decreased in value. Roth conversions are now final in the year of the transaction.
Roth funds cannot be withdrawn for five years without penalty – If an investor needs IRA money to live on, it is unwise to convert to a Roth IRA. Withdrawals from a converted Roth IRA are subject to a 10% penalty tax if the withdrawal occurs within five years of the conversion and the investor is below age 59 1/2.
Quarterly income tax payments may need to be made– The taxation of a Roth conversion occurs in the year of conversion. If a substantial Roth conversion occurs early in the year, quarterly income will increase and estimated quarterly taxes may need to be paid. If waiting until the tax filing deadline, extra penalties and interest may be owed on taxes not promptly paid. You should consult your tax advisor to see whether you might be able to use an exception to quarterly payments based on paying 110% of last year’s liability.
Don’t forget about states taxes – A Roth IRA conversion is a taxable event for state income taxes as well. One strategy may be waiting to convert Roth funds when moving to a state with a lesser tax rate, or one with no income taxes. Conversely, converting to Roth before retiring to a state with higher income taxes may be a very beneficial long-term strategy.
Tax deductions may offset the tax cost of a Roth IRA conversion. Tax deductions that reduce ordinary income, such as charitable contributions to qualified charities or a donor advised fund, will reduce the taxes owed on Roth conversions. Other itemized deductions will also reduce the amount of tax owed on a Roth conversion.
Roth conversions do not count toward an RMD – A Roth conversion does not count toward a required minimum distribution (RMD). If pre-tax funds remain in an IRA account, an RMD will need to be taken as if no Roth conversion occurred since RMDs are based on the balance in the traditional IRA as of the prior year end, before the conversion.
Roth Conversion and the 2019 SECURE ACT
The 2019 SECURE ACT changes the taxation of retirement accounts. The new law requires IRAs inherited by people other than spouses to be distributed fully within 10 years, rather than stretched over the beneficiary’s lifetime as was previously the case. Spouses may still treat an inherited IRA as their own and withdraw money over their lifetimes.
This change in law may make Roth conversions more important for multi-generational wealth creation. If the money is intended for heirs whose tax bracket is likely to be at least as high as the account owner’s, a Roth conversion may save on taxes. This may be true when passing on assets to heirs in their peak earning years who now must fully withdraw IRA accounts in 10 years. A retiree might not want to convert if the money will likely go to young grandchildren or other heirs in lower tax brackets.
Side bar: Should I Invest in a Roth 401(k) or Roth IRA?
Many companies have a designated Roth 401(k) option that are subject to the same rules as Traditional 401(k) contributions. In addition, anyone with earned income can contribute to a Roth IRA within certain income limits (explore backdoor Roth IRA strategy). One strategy may be to start now making ongoing contributions to a Roth option at work or a Roth IRA. When retired, there will be a mix of retirement withdrawals without making a conversion. This is known as tax diversification.
For most high-income earners, the tax deduction of a traditional 401(k) is often most advantageous. However, given the SECURE ACT and historically low income tax rates, there may be a strong case for regular Roth 401(k) contributions. This is another area where a long-term financial planning projection can provide value.
Strategic Asset Allocation Across A Balance Sheet
Investors must view their investment portfolio holistically and focus on tax efficiency by allocating tax advantaged accounts strategically. In general, tax-efficient investments should be made in taxable accounts. Investments that are not tax-efficient are better off in tax-deferred or tax-exempt accounts. Below is an example of how an investor may allocate efficiently over a variety of accounts with different tax statuses.
One of the core principles of investing—whether it is to save for retirement or to generate cash—is to minimize taxes. Strategic allocation from a tax perspective should give your accounts the best opportunity to grow over time. Remember, it is not what you make, but what you keep!
Evaluating the Roth Conversion Decision: Once-in-a-market-cycle opportunity
With asset values beaten down and income-tax rates scheduled to increase in 2026 when tax cuts expire, 2020 may be a great time to consider a Roth conversion strategy. Managing the tax impact of a Roth IRA conversion requires careful analysis and the decision to convert to a Roth IRA cannot be made in a vacuum. Any decision to convert must be based on personal financial status, current tax rates, anticipated future tax rates, goals, age, and estate planning intentions. The calculations can be quite complex and often lead to multiple decision points.
If funds are available outside of retirement accounts to pay for taxes and retirement account tax rates are estimated to be high, a Roth conversion can make great financial sense. If not, you may be better off leaving funds in a traditional IRA. In these times of stress and financial ambiguity, it is vital to analyze and decide from a clear place of understanding. Working with a Financial Advisor who can objectively review the facts and circumstances is essential.