Retirement Planning
Why you should consider a Roth conversion.
The disruption from the COVID pandemic has had far reaching and widely felt economic consequences. One such notable consequence has been a large sell off in the public equity markets. As a result, holders of qualified retirement accounts and IRAs have likewise seen their retirement balances significantly reduced. And in spite of where share prices are on a given day, significant volatility and large fluctuations may continue for some time.
Many owners of retirement accounts, of course, take a long-term perspective on asset management and generally shy away from attempts to time the market. When asset values are severely depressed, however, qualified plans and IRAs may present a significant tax planning opportunity through a Roth conversion.
Under a Roth conversion, the owner of an IRA or a qualified account (that permits in plan conversions) realizes income on converted amounts while retaining the balance inside the qualified account or IRA. Once converted to a Roth, the balances continue to enjoy tax-free growth while also avoiding income tax on subsequent distributions in retirement.
Primary reasons to consider a Roth conversion in the current environment:
1. Converting while asset values are down subjects a smaller amount of income to taxation. Assuming asset values rebound, the gains accrued beyond the conversion would continue to appreciate tax-free and avoid income tax when distributed. For example, assume a 30% income tax rate applies to a Roth conversion based on values in the table.
The long-term impact of taking advantage of a down market can also be significant. Assuming a $167,500 IRA, a steady 7% annual appreciation rate, and 30% income tax rate, a conversion would generate approximately $35,000 in savings after 15 years. If the conversion is made during a downturn, however, and asset balances rebound as shown above and then appreciate steadily, a conversion would result in savings of over $90,000.
| Hypothetical IRA Balance | |
|---|---|
February 2020 |
$250,000 |
April 2020 |
$167,500 |
February 2021 |
$250,000 |
Income taxes on Roth conversion in April |
$50,250 |
Income taxes saved on rebound in values |
$24,750 |
2. A Roth conversion generates taxable income that can be offset with other losses. Many individuals and businesses have been adversely impacted by COVID, experiencing reduced income levels and/or potential losses. The tax liability on ordinary income generated by the conversion may therefore be reduced or offset by ordinary losses generated outside of the plan. Capital losses can additionally offset ordinary gains but are typically limited to $3,000 of such income.
3. A Roth conversion at current tax rates may be more attractive than realization in the future when tax rates may be higher. Legislation in late 2017 reduced federal income tax rates in many respects; however, such law is scheduled to expire in 2026. As a result, a Roth conversion in the near term may be taxable at potentially lower rates. Additionally, many account owners may have reduced income in 2020, placing them in a lower income tax bracket for the year. Lastly, the prospects for higher income tax rates in the future is always a risk, perhaps more so in light of significant federal outlays and sizable deficits as a result of the COVID pandemic.
Several additional important points to note about Roth conversions:
- Roth conversions are primarily effective when the tax liability is satisfied by non-qualified dollars that are outside of the plan. Account holders who are therefore uncomfortable giving up the liquidity necessary to satisfy the tax liability may not be good candidates for conversion. Additionally, account owners under age 59½ who use plan funds to pay the tax on conversion may incur an additional 10% penalty.
- A partial conversion of qualified accounts and IRA balances is possible—the entire plan balance need not be converted. Note, however, that any basis in the qualified account or IRA as a result of after-tax contributions cannot be selectively converted. Conversions are deemed to come pro-rata from combined IRA balances. In-plan conversions of qualified plans are deemed to come pro-rata from the specific balance in the plan itself.
- While a recharacterization of a Roth conversion was previously permitted (e.g., if assets decreased in value post conversion, making the conversion unattractive), recent changes in the tax law eliminated recharacterizations.
- In order to avoid taxation on gains accrued in a Roth, the owner must maintain the account for a minimum of five years. Note that this rule applies from January 1st of the year of conversion and applies regardless of whether the owner has reached age 59½ (the age at which tax-free gains can otherwise be taken from a Roth account).
- Under the recent CARES Act qualifying individuals can take a COVID related distribution of up $100,000 from their IRA or qualified plan and pay the tax liability over 3 years. It does not appear that a Roth conversion would qualify for the 3-year tax realization, as a conversion is not generally considered a distribution. Nor does it appear that the 3-year repayment rule for COVID distributions would apply to contributions made to a Roth, as such contributions are treated as rollovers rather than conversions.
Recent events have resulted in significant market disruption and economic turmoil. While such conditions will eventually abate, it is worthwhile to consider potential planning opportunities as well. For many owners of retirement accounts, a Roth conversion may be one such opportunity worth pursuing.
About the author
Brooke Zrno Grisham
ChFC®, CLU®, AEP®, is the Chief Executive Officer of The Nautilus Group®, a service of New York Life that provides exclusive support to high net worth individuals and closely held business owners in the areas of estate, insurance, retirement and business exit planning, income tax strategies, planning for families with special needs individuals, and charitable giving.
This material includes a discussion of one or more tax-related topics and was prepared to assist in the promotion or marketing of the transactions or matters addressed in this material. It is not intended (and cannot be used by any taxpayer) for the purposes of avoiding any IRS penalties that may be imposed upon the taxpayer. Nautilus, New York Life Insurance Company, its employees or agents are not in the business of providing tax, legal or accounting advice. Individuals should consult with their own tax, legal or accounting advisors before implementing any planning strategies. © 2020 New York Life Insurance Company. All rights reserved.
