Roth Conversions

Published On: March 27, 2020

Written by: Ben Atwater and Matt Malick

As long-term investors, we must occasionally suffer through bouts of volatility and steep short-term equity losses.  The trade-off is that stocks have historically delivered robust long-term returns despite extreme drops of 30%, 40%, 50% or even more along the way.

During periods of sharp declines, however, investors can sometimes take action to improve their long-term tax situation.

One such move is the Roth IRA conversion.

With a traditional IRA, contributions are tax-deductible (pre-tax), the funds grow tax-deferred until retirement and the IRS taxes withdrawals as ordinary income.  With a Roth IRA, which the Taxpayer Relief Act of 1997 established, no current income tax deduction is permitted when you make contributions, but the funds grow tax-free and withdrawals are tax-free.

A Roth conversion allows an investor to convert pre-tax funds from a traditional IRA to a tax-free Roth IRA.  However, the amount converted is then considered ordinary taxable income in the year of the conversion.

In our opinion, a Roth conversion rarely makes sense because, instead of paying taxes on traditional IRA withdrawals over the course of a multi-decade retirement, you pay all the taxes up front.  One of the basic rules of finance is that a dollar today is worth more than a dollar tomorrow, so paying taxes later is typically better than paying taxes now.

Under the following circumstances, however, a Roth conversion can work well.

Depressed Stock Market

Consider an investor who had a $500,000 IRA on December 31, 2019 and the value has now dropped to $325,000.  If this investor performs a Roth conversion now, he will report $325,000 in ordinary income on his 2020 tax return.

The income tax liability on this much additional income is clearly nothing to sneeze at, but the future tax benefits are compelling.

If we assume that the stock market ultimately recovers over a period of years and the account realizes average annual growth of 6% over the next 20 years, the same account would be worth $1,042,319 by the year 2040.  The investor can withdraw the full account value, including the roughly $717,000 of appreciation, tax-free in retirement.  If the investor dies with a balance left in his Roth IRA, his beneficiaries can also withdraw the funds tax-free.

Cash on Hand

The primary cost of a Roth conversion is the ordinary income tax due on the market value of the conversion.  And in order to pay this tax due when you file your 2020 taxes, you should have the cash on hand.

If we assume our hypothetical IRA investor above has an effective tax rate of 25% on the Roth conversion amount, his tax bill would be a whopping $81,250.

Because of the current income tax obligation, Roth conversions tend to work best in years when other taxable income is depressed.  For this reason, retirees are prime candidates, as are business owners who expect the recession to temporarily depress their profits.  Given the havoc that the coronavirus is wreaking on our economy, 2020 may indeed meet that description for some.

Higher Future Tax Rates

Roth conversions also work well if the current rate of taxation on the converted amount is lower than the rates that will apply to future IRA withdrawals.  For example, if our investor’s current effective tax rate is 25% but he expects the federal government to raise marginal tax rates substantially in the future, then it may behoove him to do the conversion now and lock in the lower rate.

Clearly nobody can predict future tax rates.  But the federal budget deficit was projected to be over $1 trillion even before Congress negotiated over $2 trillion in stimulus bills to fight the economic damage from coronavirus shutdowns.  Couple massive government spending with a shrinking economic base and lower tax revenues and it seems inevitable that tax rates will rise in coming years.

New Inherited IRA Rules

Among the provisions of the SECURE Act, a new retirement bill that became law on January 1, 2020, was a change to the treatment of inherited IRA accounts.

Under previous rules, non-spouse beneficiaries of traditional IRAs could stretch out required minimum distributions over their lifetimes.  For example, if our investor named his 50-year-old daughter as his sole traditional IRA beneficiary, she would calculate a required minimum distribution each year, based on her life expectancy of over 30 years.  Under the SECURE Act, she must withdraw the full value within ten years, greatly diminishing her ability to defer income taxes.

The SECURE Act also requires that non-spouse Roth IRA beneficiaries withdraw all funds within ten years.  But for Roth IRA beneficiaries the withdrawals are completely tax-free at any time during this period. 

Additionally, with the new fiscal stimulus that Congress is about to pass, required minimum distributions (RMDs) are suspended for 2020, which makes Roth conversions even more appealing for certain IRA owners. 

Roth conversions are not for everyone but if you have a traditional IRA (or a 401(k) that is eligible for a rollover) and cash on hand to pay the taxes, then a conversion could potentially save a great deal of taxes over your lifetime and the lifetimes of your heirs.

We will be reaching out individually to clients who we think can benefit from this planning opportunity, however, if you find this a compelling idea for your situation, please give us a call.