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Three New Reasons to Consider Roth IRA Conversion After COVID-19
Roth IRA conversions have been available for many years. You may have already done one. Three recent developments suggest that you reconsider Roth IRA conversions (particularly if you have funds outside of IRAs or other retirement plans from which to pay the tax):
Each one of these factors makes Roth IRA conversions more attractive than they were in 2019. The decision as to whether these factors tip the scale in favor of a Roth IRA conversion will require careful consideration. You will need to consider your overall financial plan and make certain assumptions.
One of the most important assumptions is what tax will be paid on the IRA when it is withdrawn.
Ideally, you will pay the tax on the Roth IRA conversion from assets that are not currently in an IRA or other qualified plan.
If you pay the tax on the Roth IRA conversion from assets that are currently in the IRA or qualified plan, you are losing out on an important benefit of the conversion: you are taking funds out of your taxable portfolio, which presumably grow at a slower rate than your IRA assets since taxes will reduce the return of the taxable portfolio over time. If you do not have an investment portfolio outside the IRA, the only way to pay the tax on the Roth IRA conversion is to take the tax out of the IRA proceeds before rolling over.
Paying the tax on the Roth IRA conversion using funds from the IRA
If you must pay the tax on the Roth IRA conversion out of the IRA proceeds, it simplifies the determination of whether the Roth IRA conversion makes sense from a tax perspective. You can calculate the current tax on the amount you are converting to a Roth IRA this year, which gives you your current tax rate as a percentage of the withdrawal. (If you are under age 59½, don’t forget the 10% excise tax on the amount you are not converting, if applicable). Then you can speculate on the tax rate that would be paid on the IRA whenever it is withdrawn in the future. Unless you expect that the future tax rate (on average) will be higher than the current tax rate, there is no benefit from a Roth IRA conversion.
Why is it that the tax rate to be paid, on average, on future IRA withdrawals is the only factor to consider when you pay the tax on the Roth IRA conversion out of the IRA proceeds? This can be explained by the commutative property of multiplication (the math rule that says the order in which we multiply numbers does not change the product). Funds in an IRA grow at the same rate as funds in a Roth IRA. In the case of the Roth IRA using funds from the IRA to pay the tax on the conversion, all of the tax is paid upfront and no tax is paid on withdrawal after age 59½ and more than five years after beginning the Roth IRA.
In the regular IRA, no tax is paid until distributions take place. In comparing the two after-tax results, no matter what the earnings rate (as long as it is positive), no matter how many years of tax deferral; the only difference in results of the Roth IRA conversion compared to leaving the funds in the IRA is the tax rate now on the Roth IRA conversion compared to the tax rate in the future on the IRA withdrawals. Thus the comparison between the Roth IRA conversion (with tax paid from the IRA) and not converting the IRA is a series of multiplications; the commutative property of multiplication tells us that the difference between these calculations is the tax rate now on the Roth conversion compared to the future tax rate on the IRA distribution.
Taxes paid from non-IRA funds
Paying the tax on the IRA conversion using funds in your taxable portfolio can result in the Roth IRA conversion being beneficial even if the funds are taxed at a lower rate when paid out of the IRA than in 2020 when the Roth IRA conversion takes place. Many more factors come into play in determining how much lower the future rate can be in order to still come out better with the Roth IRA conversion.
One of the most important is the tax rate and frequency on which taxes are paid on the taxable portfolio. If you pay the tax on the Roth IRA conversion using cash that would otherwise be invested in index funds through Exchange Traded Funds or tax-efficient equity mutual funds, the benefit of paying the tax on the Roth IRA conversion is far less than if you would have invested the cash used to pay the tax in hedge funds or other investments paying ordinary income every year. Another important factor is the number of years before the IRA payments begin. The younger you are, the more time that you have to benefit from taking earnings out of your taxable portfolio. The older you are, the shorter the investment horizon and the greater chance that earnings inside the Roth IRA will not be sufficient to make up for the up-front payment of taxes.
Who should do a Roth IRA conversion?
To summarize, the ideal candidate for a Roth IRA conversion would check off most or all of these boxes:
Who should not do a Roth IRA Conversion?
Some reasons not to do a Roth IRA conversion currently are as follows:
Partial Roth IRA Conversions and Serial Roth IRA Conversions
Any portion or all of an IRA can be converted to a Roth IRA. Also, qualified retirement plans can in some cases be rolled over into an IRA and some retirement plans permit the equivalent of a Roth IRA—the Roth 401(k) plan. Partial conversions and serial conversions allow you to fine tune the amount of Roth IRA conversion that makes sense for you. This year you may have a lower income year than usual. You may want to convert a portion of your IRA to a Roth IRA to take advantage of your lower tax bracket.
In addition, the CARES Act suspended the Required Minimum Distribution (RMD) requirements for 2020. If you do not need to take an IRA distribution, you may choose to use that amount for a Roth IRA conversion. If you retire early and are not eligible for Social Security or decide to wait until a later age to collect your Social Security, you may benefit from serial Roth IRA conversions to take advantage of the lower tax brackets during the years prior to receiving your RMDs and/or Social Security benefits.
Things Can Go Wrong
Even ideal candidates could end up, in hindsight, less well off by doing a Roth IRA conversion:
Worse Yet: The Possibility Of Congressional Tax Law Changes
In addition, there is the possibility of specific changes in the tax law regarding Roth IRAs that would diminish the value of the conversion. There are innumerable ways in which Congress could change Roth IRAs, including:
It is for reasons such as these that some advisors and taxpayers are hesitant to pay tax now for the possibility that the Roth IRA conversion will create greater future wealth. The future is of course uncertain and unknowable. However, this should not cause paralysis.
There is a low probability that anything will happen in the future which would make the Roth IRA conversion undesirable for those taxpayers who meet most or all of the criteria mentioned above. The Roth IRA conversion decision should be based on the reasonably expected future scenarios taking into account each person’s individual financial situation. Partial Roth IRA conversions allow taxpayers to hedge their bets on the many future unknowns. Having the choice to withdraw from a taxable portfolio, an IRA and a Roth IRA creates additional flexibility.
The contents in this article are being provided for educational and informational purposes only. The information and comments are not the views or opinions of Union Bank, its subsidiaries or affiliates.