by Kevin Kroskey, CFP, MBA
Recently the stock market has taken a sharp decline. The depressed prices make it a great time to consider converting some of your tax-deferred assets in your IRA or similar retirement plans into a tax-free Roth IRA. The idea is that since prices have quickly and sharply declined, by converting now, tax will be paid on the depressed amount and therefore less tax will be due. As the market recovers, the gains will occur in the Roth IRA and be tax free.
Who Can Benefit from a Roth Conversion
While there are many potential benefits of a Roth IRA conversion, it is not universally advisable. Yet, some common characteristics are typical of people that are most likely to benefit from executing the strategy. These characteristics are that these people have funds available outside or retirement plans to pay taxes due, expect to be in a similar or higher tax bracket in the future, and have a long time horizon for the converted funds.
Funds held outside of retirement plans typically generate taxes to be paid yearly via various distributions, including interest, dividends, and capital gains, from the investments. These distributions create a tax drag and can commonly cause an investor to lose 20% or more of the pre-tax return. For example, if the pre-tax return is 8%, the net return the investor receives after the tax drag due to distributions is 6.4%. In dollar terms, assuming a $1M portfolio, that is a loss of $16K each year. By utilizing tax inefficient assets to pay taxes for Roth IRA conversions, tax drag can be reduced and after-tax wealth can be increased.
Tax drag is a primary reason why time horizon is a key consideration. As investments compound over time, the annual loss due to the tax on distributions causes more profound effects in reducing after-tax wealth. Continuing the example of the $1M portfolio, over ten years tax drag creates a loss of after-tax wealth of an astounding $300K and an even greater $1.2M over twenty years.
As for income tax rates, the tax rate differential between the time funds are converted to the time when they are distributed is key. For example, making a conversion today in a 25% marginal tax bracket when the funds could likely be distributed in a 15% marginal tax bracket later would not be justifiable. Yet, if the conversion could be made in the 15% tax bracket today, it is generally a good idea to do so, as it is unlikely that any lower of a tax rate could reasonably be expected.
Today’s income tax rates extended by Congress at the end of 2010 through 2012 are very low relative to historical rates. And though future tax rates cannot be predicted any more so than future investment performance, it is likely that tax rates will need to be higher in the future for the U.S. to get its fiscal house in order.
Why Retirees Make Great Conversion Candidates
Quite often an affluent retiree in their late 50s or early 60s is an ideal candidate for the strategy. This is so because they tend to meet the three key characteristics described above quite well and tend to have much greater control over their tax planning now that they have retired.
For instance, retirees may not have begun to take income from pensions or Social Security. Retirees may also choose to take money to support their lifestyle from tax-deferred retirement accounts, which incur tax upon distribution, or they may take money from their non-retirement accounts. The latter is often more preferential as taxes will only be due on net capital gains. Because of this flexibility, it is common to see even affluent retirees in the 15% tax bracket in these earlier years of retirement. Yet, if proactive planning is not done, there can be substantial unintended consequences down the road.
For the affluent retiree described above with $1M in non-retirement account assets, let’s also assume they have accumulated another $1M in tax-deferred retirement accounts and retire at the age of 60. Following a distribution plan of spending their non-retirement account assets first, the tax-deferred retirement accounts will double over a ten year period at a 7% investment rate of return. Now the retiree is nearing time to begin required minimum distributions, which start at a rate of roughly 4% of the account balance and increase on a percentage basis yearly.
At this time the tax-deferred retirement accounts now total $2M and the 4% required distribution results in $80K of taxable income at the income tax rates in effect at that time. These distributions often cause the reactive retiree to be pushed into increasingly higher marginal tax rates. Taking the approach of proactive tax planning and incorporating a Roth Conversion strategy will likely result in greater after-tax wealth.
Implications for Investors
With the recent market declines, now is a good time to evaluate the potential benefits of a Roth Conversion strategy, as the gains from the market recovery could be realized tax-free inside a Roth IRA. Those who have funds available outside or retirement plans to pay taxes due, expect to be in a similar or higher tax bracket in the future, and have a long time horizon for the converted funds tend to be well suited to realize benefits from this strategy. Affluent retirees particularly are well situated to realize increased after-tax wealth by doing so.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.