By Sheryl Rowling - 20 Sep 2019 - Morningstar
Roth IRA conversions might seem like old news, but today’s tax and economic environment warrants a fresh look at the benefits of converting a traditional Individual Retirement Account to a Roth. As always, a client’s changing needs may alter the analysis and make conversion suitable where it wasn’t before. What’s new is the likelihood of rising tax rates down the road and a rocky stock market. This combination makes conversions particularly attractive for many retirement savers today.
The Tax Cuts and Jobs Act of 2017 produced some of the lowest tax rates in recent history—and they are unlikely to stick. Most Americans expect income tax rates to increase in the future. This seems like a safe prediction considering the growing size of the deficit combined with today’s historically low rates. That means traditional IRA owners will likely be looking at a higher tax rate applied to both principal and growth when they make withdrawals in the future.
In this context, converting assets to a Roth IRA would provide a rare opportunity to pay taxes up front at a discount. Unfortunately, many people will hesitate to take advantage of this option simply because they don’t want to write a check to the IRS today. Here’s where education and guidance from an advisor can prove its worth.
The second variable at play today is a volatile stock market that might periodically depress a client’s IRA value. Converting to a Roth during such a time can change a downturn into a tax advantage. For example, let’s say your client has an IRA worth $80,000 that drops to $70,000 during a market dip. Converting at this point would trigger tax on only that $70,000 even if the account recovers by the end of the year.
In fact, given the current tax and economic circumstances, clients may want to consider maxing out Roth conversions.
A simple example: Karyn, who has an IRA with a balance of $1.5 million, has plenty of outside cash and taxable investments to cover the tax costs of a conversion; she will not be reliant on the required minimum distribution when she retires in 10 years at age 65; and she lives in Nevada where there are no state income taxes. She currently pays taxes at the highest federal rate and does not expect that to change when retired. If Karyn were to convert her entire IRA balance of $1.5 million to a Roth IRA, she would incur tax of $555,000, given a 37% tax rate.
That’s quite a steep cut, but it could pay off dramatically in the long run. Using a scenario with a 37% tax on traditional IRA distributions, a 30% tax on investment income, and a growth rate on the account of 7% per year, if Karyn died at 90, her heirs would receive a little over $9 million if she remained in a traditional IRA taxed at her death. (Click on images for better viewing).
But had she converted the entire account over to a Roth at the age of 55, her heirs would receive a bit more than $13 million. That’s the advantage of long-term compounding uninterrupted by mandatory withdrawals.
And that example assumes no change in tax rates. If rates do indeed increase, the advantage of converting to a Roth would be even more pronounced. Assume a small change in five years from 37% to 40% for ordinary income, and from 30% to 32% on investment income. In this case, the traditional IRA scenario would produce only $8.5 million for Karyn’s heirs.
This compares with the result of $13 million in a Roth.
Even greater savings might occur should tax rates increase further, and/or if the conversion takes place during a market low. Advisors should seriously consider Roth conversion for clients—even for those who were not good candidates in the past. Of course, each client is different and more-detailed tax considerations need to be taken into account, such as impacts on Social Security taxability, surtaxes, and state income taxes. But, given historically low tax rates and high market volatility, this might be the time to convert as much as possible to a Roth.
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