Recent market drawdowns have created opportunities for some investors to convert their traditional retirement accounts to Roth IRA’s. Stocks have bounced off of their lows, yes, but with continued volatility, there are likely to be ongoing opportunities for this tax-savvy strategy.
When you do a Roth IRA conversion, you’ll owe income tax on the value of whatever you convert, but then you won’t have to pay anymore tax going forward, whereas with a 401(k) or traditional IRA, you’ll pay ordinary income tax on whatever gets withdrawn. (Roth IRA’s are funded with after-tax dollars, so the investments grow not just tax-deferred but completely tax-free.) Roth conversions make sense in a variety of situations, but today’s market and recent legislation make the move all the more compelling. Most asset classes have taken a beating this year, so generally speaking, a conversion will cost less in taxes today than it would have a few months ago.
In other words, if you’re in a 32% tax bracket and your IRA was worth $100,000 but has now dropped to $80,000, your cost to convert today would have fallen to just $25,600 as opposed to $32,000 in taxes to convert the same account earlier this year. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a traditional IRA to a Roth IRA.
Also, thanks to the retirement system overhaul legislation passed late last year, Roths now often make sense for estate planning purposes. Before this year, IRA beneficiaries could stretch distributions—and, in turn, the tax—over their lifetimes. Now, under the Secure Act, non-spouse beneficiaries need to pay taxes on inherited IRAs within 10 years. With a Roth IRA, you can essentially leave money to your beneficiaries without those tax consequences.
There are other reasons to consider a Roth conversion, too. First of all, you don’t necessarily need losses across your entire portfolio for a Roth conversion to pay off. Typically, it makes sense to look at the positions that have been drawn down the most; you don’t have to convert the entire account. Also, it’s significant to note that we utilize this strategy in all kinds of markets, especially if a client drops into a lower tax bracket. For example, new retirees might have a window of low taxes before they claim Social Security benefits, or business owners and investors with pass-through losses might also use unusual tax years to their advantage. Finally, Roth conversions are attractive to many investors as a hedge against future tax increases; if the government decides to raise taxes, Uncle Sam gains a bigger share of your retirement savings.
We see future income tax increases as likely for a variety of reasons. Nobody can predict future taxes, of course, but our collective hunch is that that’s where we’re heading. Unprecedented federal spending due to the Covid-19 pandemic is adding to an already staggering U.S. debt, and we don’t think the world will continue to loan the U.S. money at 0.65% for much longer. Moreover, we see the likelihood of tax hikes under a Joe Biden administration as likely, so his emergence as the Democratic Presidential nominee is meaningful for those considering a Roth conversion for the sake of hedging against tax increases. The possibility that tax rates will be higher in the future is a significant reason to consider a Roth conversion.
There are two final tax matters for investors to consider whenever evaluating the value of a Roth conversion, but perhaps even more so during these turbulent times. The first one is pretty obvious-- you have to have cash to pay the tax tied to the conversion. In these uncertain times, cash is still king for many families, so if you have adequate reserves but still feel nervous, you might want to do the conversion in phases. The other thing is that you want to remember that any pretax dollars you convert to a Roth are considered taxable income, so you want to make sure your Roth conversion won’t bump you up into a higher tax bracket.
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