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Revisiting Roth Conversions

Sheryl Rowling (Sheryl.Rowling@morningstar.com)

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.

First, a review to illustrate the advantages of a conversion: Traditional IRAs, as well as employer-sponsored SIMPLE IRAs and SEP-IRAs, are funded by pretax dollars. Because the funds generated a tax deduction upon original contribution, they are taxed upon withdrawal. Additionally, although capital gains and income are tax-deferred inside an IRA, withdrawals are taxable in full at ordinary income tax rates. Roth IRAs are almost the inverse of IRAs. There is no tax deduction when contributions are made to the account. However, withdrawals are completely tax-free (assuming the account has been in existence at least five years). In other words, a Roth owner never pays tax on the account's earnings.

There is one other major difference between Roth IRAs and IRAs: IRA owners must take required minimum distributions, or RMDs, once they reach age 701/2, even if they don't need the cash flow. That results in regular taxable income recognition. Because RMDs are not required for Roth IRAs, these accounts can earn tax-free returns over a longer period of time.

Conversion Considerations
Subject to income limitations, the maximum allowable contribution is $6,000 per year for those under age 50 and $7,000 for those 50 and older. But as of 2010, taxpayers can convert an unlimited amount of an IRA balance to a Roth. That comes with the cost of recognizing taxable income in the amount of the conversion— but it also means the permanent avoidance of tax on future growth in the account. For those in middle and high tax brackets, the decision of whether and how much to convert to a Roth can require a complex cost/benefit analysis.

Sometimes, however, the answer is easy. For any taxpayer with a year of negative taxable income, it makes sense to do a Roth conversion to the extent that no tax is generated. This may occur during a year when itemized or standard deductions exceed income, or when there are substantial business losses or net operating loss carryforwards. In my opinion, any financial advisor or CPA who fails to recommend a Roth conversion in a year of negative taxable income could be subject to a malpractice claim.

For those in a low tax bracket, it might make sense to convert an amount that will take full advantage of the lower bracket. For example, a single taxpayer might want to convert an amount that will bring taxable income to $39,475, the top of the 12% bracket in 2019. Or a client with negative taxable income of $11,000 might choose to convert $50,000 of IRA savings to a Roth IRA, resulting in taxable income of $39,000 and a federal tax of only $4,680. This is a very reasonable price tag to be able to fully avoid tax on principal and earnings forever.

A recent wrinkle: To qualify as a Roth conversion, the transfer must occur by the end of the year—and as a result of the Tax Cuts and Jobs Act of 2017, recharacterizations after year-end are no longer allowed. Before the act, taxpayers could “unconvert” part or all of the transfer by recharacterizing it before the due date of the tax return (including extensions). So, in the above example, if the client converted $50,000 and, upon preparing the tax return, discovered that taxable income was $10,000 higher than expected, $10,000 of the converted amount could be recharacterized after year-end. Given that this type of maneuver is no longer possible, it might be best to be conservative when estimating taxable income to ensure that the conversion does not trigger a higher tax than planned.

Since all clients have different situations and different preferences, there are no definitive lines indicating yes or no on a decision to do a Roth conversion. However, there are some general guidelines, as shown in the exhibit.

The factors in the con column can be stop signs. If there are no outside funds to pay taxes, then converting an IRA to a Roth means withdrawing money to cover the tax payments as well—resulting in additional tax cost.

For example, a client in the 40% tax bracket who wants to convert $100,000 from a $200,000 IRA would need to withdraw $166,667 to cover the taxes. And note that withdrawals used to pay tax can be subject to early distribution penalties if the taxpayer is under age 591/2.

If marginal rates are likely to decrease in the future, it might be beneficial to delay Roth conversion. And, if the funds must be depleted over time for cash flow purposes during the retirement years, the immediate tax on the Roth conversion may not be offset by avoiding tax on future growth. Similarly, if the IRA is to be left to a charity that won't owe taxes on the funds, taxes on a conversion won't be offset by a tax savings later. 

Good Timing
For many clients, however, the time is now right to evaluate, or reevaluate, a Roth conversion. First, the Tax Cuts and Jobs Act 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 account value. Converting to a Roth during such a time can turn 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: Let's say 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, will not be reliant on RMDs when she retires in 10 years at age 65, and 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. Let's assume a 37% tax on traditional IRA distributions, a 30% tax on investment income, and a growth rate on the account of 7% per year. In that scenario, 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. 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.

Moreover, 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, compared with the $13 million result in a Roth.

Morningstar Office subscribers can find tables detailing the numbers in this example in a version of this article at https://office.morningstar.com/research/doc/946727/magazine.

This scenario makes a compelling case for an all-out Roth conversion. 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.


A version of this article originally appeared in Winter 2019 edition of Morningstar Magazine. To learn more about Morningstar magazine, please visit our corporate website.