Is a Roth conversion right for you?
Amidst the recent market downturn, this is a question you may be asking yourself. First, let’s start from the top with a brief explanation of the benefits and characteristics of a Roth IRA. Assuming you’ve met the guidelines outlined by the IRS, a Roth IRA, unlike a traditional IRA, is funded with after-tax dollars and allows you to grow your account and take distributions tax-free in the future. While you’re not able to contribute to a Roth IRA if your income exceeds the limits set forth by the IRS, there’s no limit as to who can convert traditional IRA dollars into Roth IRA dollars, otherwise known as a Roth conversion or a “backdoor Roth IRA.” You’re paying taxes on the converted IRA amount now, to then fund your Roth IRA in hopes of taking tax-free withdrawals in the future. It’s important to note, the amount converted will be included in an individual’s gross income and taxed at ordinary income rates.
There’s additional benefits to funding Roth accounts such as staying diversified among account types, e.g. taxable accounts (joint account), tax-deferred accounts (IRA), and tax-free accounts (Roth IRA). Unlike a traditional IRA, it’s not mandatory to take required minimum distributions from Roth IRAs. Required minimum distributions, better known as RMDs, are forced distributions investors must take starting at age 72, recently changed from 70.5 by the passing of the SECURE Act. Just as most distributions from qualified accounts, such as IRAs and 401(k)s, the investor will include these amounts within their gross income for the year. For someone who is on Medicare and / or drawing Social Security, your RMDs will affect both the premiums for Medicare and the taxation of Social Security as the two are affected by an individual’s adjusted gross income. Since qualified distributions from Roth accounts are tax-free, this will have no bearing on either Social Security payments or Medicare premiums.
So how does a market sell-off create an opportunity for Roth conversions?
By converting after a downturn in the market, you’re paying taxes on a smaller investment portfolio, meaning you’d pay less in taxes overall. For example, let’s assume a single taxpayer converted a $1,000,000 IRA to a Roth IRA one month ago. Assuming no other income for the year, their tax bill for 2021 will be roughly $334,000. Now, let’s assume it’s one month later and the individual has seen a 10% drawdown in their account. The $1,000,000 account is now only worth $900,000. If they had waited until after the market drawdown to convert their IRA, they would have paid approximately $297,000 in taxes, a tax savings of about $37,000. This simple example illustrates how it could be beneficial to convert assets when they’re lower in value rather than higher in value.
It should be noted that it’s not necessary to convert your entire account, and from a tax standpoint, it is usually more beneficial to come up with a Roth conversion plan over a number of years rather than converting one large account all at once. One way to do this would be to “fill up” your current marginal federal income-tax bracket with a Roth conversion. For example, a single taxpayer with $100,000 of taxable income would be in a marginal tax bracket of 24%. This would allow for the taxpayer to convert over $60,000 to their Roth IRA without creeping into the next-highest bracket of 32%.
If savers believe their tax rate is lower now than it could be in retirement, a conversion may make sense as it could save them money in the long run. Tax rates are currently low by historical standards and many experts believe they are likely to increase (rather than fall further) in the future, given the eventual need to raise federal revenue to reduce the U.S. budget deficit. We also know that tax rates are scheduled to increase, back to 2017 rates, in six years under the Tax Cuts and Jobs Act.
Additionally, many people have unfortunately seen a drop in their income and portfolio values due to the current pandemic. While this is not ideal, it too could create an opportunity for a conversion. Ultimately, it’s important for an investor to work with their financial planner and CPA to make a decision as to whether or not a Roth conversion makes sense given their current situation.
If you would like to discuss how this strategy and others could be right for you, please don’t hesitate to reach out to our team to see how we can help.
Ben and Derek
Co-Founders and Owners of Aspire Wealth
*Please note, this is not intended to be advice. We are not tax experts and you should work with your financial planner and CPA prior to implementing any strategies we’ve discussed.
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