The Toll

For years—decades!—you’ve been diligently packing away dollars in tax-sheltered retirement accounts. You’ve been disciplined. You’ve avoided the temptation to “raid the cookie jar.” You’ve stuck with your investments through market ups and downs on the ride to the top. Your past actions are commendable, but now, as always, it’s time to think about your financial future.

Your dollars’ happy existence inside those tax-sheltered accounts won’t last forever. The taxman will collect his toll when the dollars cross the bridge from your pre-tax retirement account to your checking account. This tax will be collected either when you decide to withdraw funds, when you are forced to withdraw funds by the Required Minimum Distribution (“RMD”) rules, or when your beneficiaries are required by tax code to withdraw funds.

The size of this toll—the tax paid on dollars withdrawn—can vary great depending on a number of factors, including the quality of your advanced planning!

THE BIG QUESTION: When should you pay this tax? Now? Or continue deferring until later?

Roth IRA Conversion

Roth IRA conversions, a long-time useful financial planning strategy, are looking more attractive than ever for more people. A Roth conversion moves money from a traditional pre-tax IRA into a tax-free Roth IRA. The golden upside: no tax will be owed on qualifying distributions from a Roth IRA, including the growth on the dollars converted! The downside: the toll to move those dollars into the tax-free Roth IRA. The dollars converted to a Roth IRA account are taxable as income in the year of conversion.

As attractive as a tax-free growth in a Roth IRA may seem, there are many complex considerations in Roth conversions. Each individual has unique circumstances that should be weighed before making a decision. Consulting with your Certified Financial Planner (CFP®) practitioner and accountant is highly recommended.

In a recent episode of my “Money Matters” radio segment with WTIP radio, Mark Abrahamson and I talk about Roth IRA conversions and some unique circumstances that people should consider:

Economic & Portfolio Considerations

Converting pre-tax retirement plan dollars to a Roth IRA during market downturns can be a good strategy. You pay income tax on compressed values during the conversion, and then you are able to capture the investment’s recovery—tax-free—on the other side in your Roth IRA!

At the time of this radio interview (May 2020), we had just been hit with historic market shock and were in the midst of Coronavirus pandemic uncertainty. While there has been a strong climb back from 2020 market lows, not all asset classes have climbed at the same pace, and not all asset classes will grow at the same rate moving forward. There may be an opportunity to convert attractive holdings that are either still depressed or positioned for outsized future tax-free growth to a Roth IRA now.

Tax Considerations

Making an informed estimate about the income tax rate paid on a Roth conversion now versus potential tax rates paid later is the heart of the Roth IRA decision. If you are able to pay taxes on the conversion at a lower rate now than in the future, it’s a win. If things work out the other way, it’s likely a loss.

Tax rates have fluctuated with economic and political cycles, and those rates will likely continue to fluctuate over the course of a 30-40 year retirement period. While it seems likely that we’ll be facing higher taxes over the next 5-10 years, no one knows for sure how things will play out during the coming decade.

Roth IRA conversions do not have to be an “all or none” proposal. It frequently makes sense to analyze the amount of pre-tax IRA dollars that could be converted and still keep the taxpayer in a low tax bracket or, at a minimum, avoid climbing into a higher bracket.

Some people are now in a position where they would be able to convert dollars to a Roth IRA with no tax or in the low 10%-12% tax brackets. The 2017 Tax Cut Jobs Act (“TCJA”) has given us a very wide 22%-24% federal income tax bracket window, which would seem appealing to many, especially since those tax cuts expire in 2026.

An advanced planning tactic is to determine which investments would be most valuable to have sitting in Roth IRAs, your tax-deferred retirement accounts, and your taxable brokerage accounts. Each of these types of accounts has very different tax treatment, and different investment holdings generate different types of taxable income. The results from this type of tax location planning don’t show up on your investment statement. In fact, the true benefit of solving this puzzle lies in what does not show up on your tax return, but rather, the positive impact on your wealth accumulation. In Vanguard’s “Advisor’s Alpha” study, they find that tax asset location planning added between 0 - .75% of net value to a portfolio each year!

Estate & Charitable Planning Considerations

The SECURE Act, which was enacted January 1, 2020 eliminated the potential for “stretch IRAs” for your beneficiaries. The new rules mandate that inherited pre-tax IRA and retirement plan balances be withdrawn and taxes paid on those dollars within 10 years of receiving. While your beneficiaries were previously able to slowly withdraw taxable dollars from inherited plans, they will now have a larger amount of taxable dollars coming their way in a shorter amount of time. This income from the inherited accounts is stacked on top of whatever income they are already earning. If you think that you would be able to pay tax now at a lower rate than your beneficiaries would pay in the future, completing a Roth IRA conversion now could be a strong family wealth planning move.

On the positive side, recent tax laws may have also created a unique window for Roth conversion planning. The SECURE Act moved the RMD beginning age to age 72 (it was previously at age 70.5). The CARES Act allowed for a waiver of the 2020 RMD. Together, these two acts potentially allow retirees and pre-retirees the opportunity to fill up lower tax brackets with Roth IRA conversion dollars, as opposed to the RMD dollars that would normally be pouring in.

For 2020 only, we also now also have the unique opportunity to deduct 100% of income with charitable contributions of cash to certain charities. Roth conversions raise income and charitable contributions are deductions from taxable income. In 2020, you could make a large charitable contribution, perhaps pre-gifting what would typically be several years worth of contributions, and use that charitable deduction to offset the income taxes on a Roth conversion of the same amount. So, you could help your favorite charitable causes, and move your personal funds to a tax-free Roth account at the same time without the usual tax bill. Talk about a win-win situation!

Along with sunsetting income tax rates, the current high federal estate tax limits are also scheduled to expire in 2026. Current Roth IRA conversions would require income taxes to be paid. Paying the income tax on some or all of your pre-tax retirement accounts now during a Roth IRA conversion would not only move those dollars to an income tax-free Roth account for your beneficiaries, but it could also potentially reduce the size of your estate tax bill by the amount of dollars (and growth on those dollars) that were used to pay the income tax bill on the Roth conversions!

The Decision

The decision to go forward with a Roth IRA conversion is complex. The interplay of tax, investment, and estate planning considerations make this a decision that should not be taken lightly. Take a look at the flowchart below for some of the considerations. However, now more than ever, paying the toll early and completing a Roth IRA conversion is looking like a golden strategy for many people.

I strongly recommend you seek qualified professional guidance before you make the decision to convert some or all of your tax-sheltered retirement accounts to a Roth IRA.

If you’d like to discuss your situation—please feel free to contact me anytime.

The flow chart below provides another look at factors to consider when thinking about a Roth IRA conversion.