Why 2020 May Make a Great Environment For Roth Conversions
Author: Nick Prigitano
If you've watched the stock market at all over the past couple weeks there have been some relatively large movements, both up and down. Much of this has to do with the uncertainty of the global economy. Some stock analysts are even going as far as predicting no earnings growth for 2020.1 As financial advisors we are not in the business of predicting where the stock market will go in the short-term, and encourage our clients to focus on the things that they can control. That's why last week we wrote a post about what you can do to prepare for disasters, and why NOT to panic about the recent stock market volatility. We believe financial planning should be focused on the long-term.
Along those lines, we are thinking of the tax planning opportunities from the current political, regulatory, and market environment. While we strongly discourage selling stocks in response to the recent market volatility, there may be some other lucrative tax planning opportunities depending on what happens for the rest of 2020.
What are Roth conversions?
Roth conversions are a common tax strategy in the financial planning universe. The way it works is you would move money from a traditional IRA (individual retirement account), which has not been taxed yet, to a Roth IRA. The amount you move from the traditional IRA to the Roth IRA is taxed at your regular income tax rate (but no penalty, even if you are under age 59 ½). However, once it is in the Roth, the money inside of it will grow tax-free and you will not owe taxes again when you take money out of it, assuming it was for a qualified withdrawal.
As an example, let's say you have $100,000 in a traditional IRA and no money currently in a Roth and are in the 25% tax bracket. You decide to do a conversion for $10,000 from your IRA to your Roth. You would pay $2,500 in taxes ($10,000 * 25%), but the money in the Roth will grow tax-free for future withdrawals.
Why would you want to do a Roth conversion?
Why would someone willingly subject themselves to additional tax you ask? Isn't the purpose of an IRA to defer tax as long as possible? Yes, there are reasons to continue to defer taxes, however, depending on your tax situation, there may be excellent reasons to accelerate paying the taxes to save money in the future.
The decision on whether to pay the taxes now or later really comes down to two questions. First, when you withdraw funds later will that extra income put you in a higher tax bracket? If you're going to be in a lower tax bracket in the future it often makes little sense to pay the taxes up front. Second, if you don't plan on using all the money in your IRA and are planning on passing it down to heirs, will their tax bracket be higher or lower than yours now? This second question can be incredibly complex, and comes with much uncertainty as tax laws are constantly changing and it is impossible to predict the future. This recently became even more complicated with recent tax law changes from the SECURE Act which changed how distributions from inherited IRAs will be taxed for many beneficiaries.
In a simple illustration, if you're in the 15% tax bracket now, and can reasonably expect to be in the 25% bracket later it may make sense to convert some money to a Roth IRA. That way, you are filling up the lower tax bracket (15%) to prevent more income being taxed at 25% later. The key is to not take too much, otherwise you can push yourself into an even higher tax bracket. If you make a significant conversion and some of the income is being taxed at a 30% marginal rate, that probably doesn't make sense if your future tax rate is 25%. That's why it's a good idea to work with a financial planner or tax advisor to help you with the tax planning for this strategy.
What happens after a Roth conversion?
Now that the money has been moved from your IRA to your Roth it is no longer subject to taxes. In essence, you prepaid the bill by taking money out of your IRA early. To keep with the previous example, if you're now 65 and withdraw $10,000 from your Roth 10 years later, you would not owe any taxes from the withdrawal. Also, the hope is that the account has increased in value over time, and those earnings are not subject to taxes either. This is another significant benefit of the Roth.
If you start with a Roth and a Traditional IRA, both at $100,000, assuming a 7% annual rate of return, in about 10 years they would have approximately doubled. Your $100,000 in earnings on the Roth will come out tax free, assuming it was for a qualified withdrawal. The earnings on the traditional IRA, on the other hand, are still subject to taxes. If you withdrew $100,000 from the IRA, and are still in the 25% tax bracket, $25,000 will be owed in taxes. Using Roth conversions to fill up a low tax bracket has two benefits. You are ideally taxed at a lower rate now, and the growth avoids those additional taxes later.
Please note, there are additional rules and nuances to the tax implications of Roth conversions that go beyond the scope of this article. We suggest you speak with a financial advisor or tax professional for additional tax details.
Why 2020 may be a great year for Roth Conversions
We'll reiterate once again, that you should NOT sell stocks due to the stock market volatility. As financial advisors we especially earn our keep during turbulent times by keeping our clients focused on their long-term goals and not the day to day stock market movements. We also focus on tax planning strategies, specifically in down markets. Who says down markets can't be a good thing? You might be able to pick up stocks on sale, and it may be a great time for Roth conversions. Now that we've gone over the basics of conversions, we'll review why 2020 may be a phenomenal year to do one.
The stock market may be lower:
As we went over in the previous example, the growth inside a Roth also comes out tax-free. Therefore, if you're able to do a Roth conversion when stocks are low, (based on past history) they will recover while inside of the Roth, saving you money on any taxes that would have been owed on the growth inside an IRA.
As an example, if you did a $10,000 conversion now and then the value of your account falls to $8,000, you will pay taxes on $10,000, but have $8,000 worth of current value. We will emphasize that no one can consistently time markets and trying to convert at the “best” price is just as speculative as trying to buy stocks at their lowest point or trying to sell right before they fall. The good news is, based on past history, the stocks will recover in the Roth effectively converting much more than the $10K (as you paid taxes on the lower amount). Note that past performance does not predict future results! But history has proved this strategy successful, time and time again.
Tax rates are historically low:
Even before the recent volatility, our financial planners have been carefully looking at Roth conversion opportunities for this reason. The Tax Cuts and Jobs Act (TCJA) that went into effect in 2018 reduced income taxes for many Americans. These tax reductions are scheduled to expire in 2025, or possibly sooner depending on the next administration in political power. Knowing that these tax rates have an expiration date, and that historically they are quite low, Roth conversions appear to be an exceptional tax planning strategy, depending on your personal tax situation of course.
SECURE Act increases RMD age:
One of our favorite times to look at Roth conversions is when someone is retired, is not yet RMD age (72), and is not currently claiming Social Security. Depending on your situation, if you're healthy, and have assets to support you in retirement we may recommend waiting until age 70 to claim Social Security for an increased benefit. Prior to the SECURE Act, RMDs (required minimum distributions) from pre-tax accounts (like an IRA or 401k) needed to begin by the year in which you turn 70.5. However, the SECURE Act increases the beginning RMD age to 72. If you're eligible for Social Security you will be collecting it by then, but you don't need to start RMDs yet. This gives financial advisors a little extra time to do additional tax planning if conversions are an appropriate strategy based on your tax situation.
Why you may not want to do conversions:
As we mentioned before, the effectiveness of a conversion depends on your tax bracket and tax situation. That's why it's critical to do tax planning before moving a large, or even small, sum of money from your IRA to Roth IRA. Also, conversions work best when you have money outside your IRA to pay for the taxes. While you can pay for the taxes from the conversion itself, that money used to pay taxes may be subject to an early withdrawal penalty (if under 59 ½), and less money actually goes into the Roth. There are more nuances to Roth conversions than just taxes. Analyzing your cash flow and savings are another critical aspect.
Also, as a rule of thumb, our advisors typically wait to do Roth conversions until the end of the year. Reason being, by that point we’ll have a pretty good picture of our clients' tax situation. Unexpected things can happen during the year, like a windfall inheritance, an unexpected large bonus, or even possibly winning the lottery! Many financial surprises can alter your tax situation and make a Roth conversion less appealing. Since we can't predict where the market will be between now and then we don't worry about the recent market volatility and whether now is the "perfect" time to do a conversion. The stock market may be higher or lower by then, but we'll have a better estimate of your overall tax situation, which is the main driver in determining whether a conversion is appropriate. That’s why we choose to wait until closer to the end of the year.
Conversions can be a great financial planning tool in an advisor's arsenal depending on a client’s tax situation. Reviewing your unique tax situation is essential for determining whether this is a good strategy for you or not. We suggest contacting a qualified financial advisor to review your situation to discuss if this is a viable strategy for you.
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