Named after Senator William Roth, the Roth IRA is a unique type of individual retirement arrangement (IRA) that was introduced by the Taxpayer Relief Act of 1997. While a traditional IRA allows you to contribute pre-tax dollars that can grow until being taxed upon withdrawal, the Roth IRA does not offer any tax benefits up front and instead allows you to benefit from tax-free withdrawals in the future. The ability to convert dollars from one type of IRA to another allows for some tax planning opportunities, especially when the stock market experiences a bear market and account values are down. By converting pre-tax IRA funds into a post-tax Roth account once the value suffers, investors can potentially be better positioned for future growth of their after-tax retirement nest eggs.
Roth Conversion Basics
Most investors are familiar with the traditional IRA, where contributions are added for investment and deducted from the investor’s income for that year. That money can grow in the market until required distributions begin at age 72, upon which every dollar taken out (both contributions and earnings) will be taxed as earned income. If the investor instead paid income tax on that initial contribution, it could be put into a Roth IRA—pending income limitations—where the future distributions would not be taxed. At any time, however, you can decide to convert some or all of the pre-tax balance in an IRA to a post-tax Roth IRA. There are no income restrictions or annual limits on executing this conversion and the process is simple. The cash and/or investments are moved from the traditional account to the Roth account and the value of the converted assets on the date of execution is reported to the IRS as income for that year. Once converted, any future growth of the investments is never taxed and there are no required distributions—the same as monies that are contributed directly into a Roth account.
Converting In Down Markets
When does it make sense to perform a Roth conversion? There are several windows of opportunity that financial planners commonly see. For example, there could exist a period of time after a client retires but before he/she begins claiming Social Security benefits when the client’s income tax bracket is quite low and there is a low tax cost to moving some of the pre-tax nest egg into a Roth account. Another time it could make sense is when the assets in a traditional IRA have suffered a decline in value, such as during the current coronavirus pandemic. If an investor believes that the stock market will eventually bounce back (as they should), paying tax today to move the investments into a tax-free account could benefit him/her in the long run because all of the earnings from the rebound will never be taxed and future tax liability in the pre-tax account is reduced or removed.
Let’s assume a client had $100,000 in a pre-tax IRA and he/she is currently in the 24% tax bracket. If the portfolio drops 30%, the account is now worth $70,000. If the client rides out the bear market and the value recovers to $140,000 in ten years, the client would have $106,400 in after-tax savings (assuming the tax bracket is unchanged, $140,000 value minus 24% income tax). Alternatively, the client could convert the $70,000 traditional IRA to a Roth IRA at a cost of $70,000 x 0.24 = $16,800. Assuming the same market return, the $70,000 grows to $140,000 over ten years but then there is no income tax liability in the Roth account! It is important to note that the $16,800 in income tax due upon conversion needs to be paid from a non-retirement account, as depleting the retirement account to pay the taxes negates the advantage of the tax-free growth in the Roth IRA. Partial conversions are also allowed, so any portion of the $70,000 account could be converted. A tax-efficient conversion amount in any given year will depend on an individual’s circumstances.
Before the Tax Cuts and Jobs Act of 2017, these conversions could be undone by the investor if desired. For example, if someone converted assets when an IRA was down 25% and then the market fell further to down 40%, it was possible to undo (recharacterize) the initial conversion and convert again. Subsequently, the tax bill would be lower due to converting a smaller balance after the additional decline. Now that the recharacterization strategy is banned, more thought must be put into the timing of a conversion. On the other hand, if a bear market presents itself, there is no telling when the market will rebound and the advantageous conversion opportunity will disappear.
A huge consideration in the pre-tax or post-tax debate is the investor’s expectation for personal income tax rates. The underlying premise is that it is best to contribute to Roth accounts while in a low tax bracket and to traditional/pre-tax accounts while in a high tax bracket. This makes intuitive sense, as the investor would be funneling retirement savings into tax-free accounts when it is cheap to do so (from an income tax perspective) and taking advantage of the tax deduction when the cost of post-tax contributions is high. The same logic applies for Roth conversions. Even in a down market, converting money to a Roth IRA may not make sense for high earners in the 37% marginal tax bracket. Conversely, retirees in those golden (tax) years before claiming Social Security could doubly benefit by converting pre-tax assets to a Roth account while in a low bracket and then also have smaller pre-tax balances to pay income tax on when they reach 72 and begin required distributions. On a long-term scale, the conversion can also make sense if the investor expects the general income tax burden to rise over time (i.e. the same amount of income is taxed at a higher rate in the future).
Another important factor to note is the availability of cash to pay the tax cost of the Roth conversion. The tax cost of a conversion should only be paid after all other cash flow needs are met and an adequate emergency fund is established. As the income taxes paid in exchange for a higher after-tax retirement account balance in the future cannot be recouped, the investor must be on solid financial footing before executing this strategy on a large scale.
The Roth conversion is a flexible strategy in that you can make conversions at any time in any amount, regardless of income. However, a lot of factors go into the decision, such as tax rates and tax expectations, other financial assets available, and current market conditions. If you would like to discuss this strategy and its implications in more detail, please do not hesitate to reach out to the financial planners at Moller Financial Services.