Roth Conversions
Roth Conversion in Down Markets – Is it the Right Decision?
By Wayne M. Lenell, CPA, PhD
The stock market is volatile and unpredictable. Overall stock values generally increase over time, but there are many periods of market decline. During the 34 years from 1986 through 2019, the S&P 500 index suffered losses in 6 years (17.65% of the time) and the market experienced 28 years (82.35%) of positive performance.
Watching a retirement investment fluctuate can be difficult. Investors saw their portfolios dive more than 50% from November 2007 to March 2009 if invested in a stock fund mirroring the S&P 500. Using humor to mask their pain, investors quipped that their 401K accounts should be renamed 201K accounts reflecting the chop in half of their investment balances.
But is there a hidden positive potential in a down market? Should someone use a down market to convert traditional retirement accounts into Roth retirement accounts? The answer is, “sometimes.”
First, let’s review the major differences between traditional retirement accounts and Roth retirement accounts.
Traditional retirement accounts.
Traditional accounts, such as Individual Retirement Accounts (IRAs), 401k or 403b retirement accounts, allow an individual to contribute to a retirement account and benefit from a tax deduction from the amount contributed. Earnings from the investments are deferred until funds are withdrawn, typically in retirement, though some scenarios allow for non-retirement withdrawals.
The concept of a traditional retirement account is that individuals receive a current tax deduction for the amount deposited in the retirement account during their years of active employment or self-employment presumably while they are in higher tax brackets. They pay tax on the withdrawals during retirement when they are presumably in lower tax brackets (e.g. receive a tax deduction while in the 24% marginal federal tax bracket, and pay tax when withdrawing funds in the 12% tax bracket.)
Roth retirement accounts.
Named for Senator William Roth who introduced the bill allowing this type of retirement vehicle, contributions to a Roth retirement account do not result in a tax deduction. An individual contributes to a Roth retirement account with after-tax dollars. With a traditional retirement account, earnings on the investments within the retirement account are deferred until the funds are withdrawn, but with a Roth retirement account, the earnings are never taxed. When a person withdraws the funds, assuming the funds have been in the account for at least five years, the withdrawals are free from tax.
Which is better?
Is it better to benefit from a current tax deduction for contributions to a traditional retirement account or to avoid paying taxes on all withdrawals with a Roth retirement account? The answer depends on the individual’s pre-retirement and post-retirement tax brackets. If a person believes that he or she will be in a higher tax bracket in retirement, then the Roth retirement account is a better vehicle for tax purposes.
A taxpayer could find himself or herself in a higher tax bracket during retirement for one of four reasons as follows:
1. A person’s retirement income could be higher than pre-retirement income. If, for example, an
Individual worked 40 years for a government agency that pays a pension benefit of 2.5% per year of service times the average of the highest three years of salary. The pension benefit would be close to 100% of pre-retirement salary. If, in addition to the pension, the individual had a supplemental traditional 403(b) plan, other investments, or continued working in retirement, the post-retirement income could be considerably higher than pre-retirement income pushing that individual into a higher tax bracket in retirement.
2. The government could increase the income tax rates in the future. Historically, Federal and state tax rates fluctuate. With record annual Federal budget deficits and national debt levels, it is not only possible but it is likely that, at some point, the government will need to raise taxes to cover its appetite for spending.
3. A person could move to a state during retirement with a higher income tax rate than in the current state of residence, if the new state taxes retirement income. For example, a person could work in the state of Wyoming, which has no state income tax, and then retire in the state of California that taxes non-Social Security retirement income with a graduated tax rate reaching 13.3%.
4. An individual could experience a decrease in tax deductions. Perhaps an individual sold his or his personal residence and began renting in retirement losing mortgage interest and real estate tax deductions, or the individual decreased the amount of charitable donations made. Lower deductions result in higher taxable incomes possibly causing the individual to step up to a higher tax bracket.
If an individual has a balance in a traditional retirement account and believes that he or she will be in a higher tax bracket during retirement, then converting a traditional retirement account to a Roth retirement account is a good tax strategy. Further, converting to a Roth retirement in down markets when an individual’s retirement portfolio has suffered a decline, will reduce the amount of out-of-pocket cash needed to pay the tax on the conversion.
Caution. Converting from a traditional retirement account to a Roth retirement produces taxable income on the amount converted. This could push the taxpayer into a higher tax bracket negating the benefits of the conversion. For example, a single taxpayer may have taxable income, before any Roth conversions, of $160,000 in 2020. The taxpayer is in the Federal marginal tax bracket of 24%. The taxpayer is also very close to the 32% tax bracket. The first $3,300 of Roth conversion for 2020 would cost the taxpayer $792 (24% of $3,300). Amounts converted in excess of $3,300 would be taxed at a Federal tax rate of 32%.
Note that you are not required to convert the entire balance of a retirement account. You may convert any amount you choose. Using the example above, the taxpayer may choose to convert just $3,300 of his or her traditional retirement account in 2020 keeping taxable income below the 32% Federal tax bracket.
Estate considerations.
Another consideration in deciding whether to convert a traditional retirement account to a Roth retirement account is the effect the retirement account has upon a taxpayer’s estate. Withdrawals from traditional retirement accounts are taxable either to the creator of the account, or to the heirs of the retirement account. Perhaps a taxpayer would prefer that a retirement account pass to the heirs without creating a tax burden for the heirs although there is no current advantage, or even a disadvantage, to the taxpayer.
For taxpayers with large estates (i.e., those in excess of $5,790,000 for single taxpayers in 2020 and $11,580,000 for married taxpayers), a retirement account as part of the estate is subject to estate taxes. The top Federal estate tax rate is 40%. Depending on the tax bracket of the heir receiving a traditional retirement account and the state of residence of the heir, the combined Federal estate tax, Federal income tax, and state income tax could take a major portion of an inherited traditional retirement account.
For example, a taxpayer has a large estate, part of which is a traditional retirement account with a balance of $1 million. The estate will pay a Federal estate tax of up to $400,000 leaving $600,000 for the heir. The heir is in the highest Federal tax bracket of 37% in 2020. The heir also resides in California and is in the highest tax bracket of 13.3%. The heir will pay $222,000 Federal tax and $79,800 California state tax leaving the heir with $298,200 after taxes. More than 70% of the retirement account balance would be consumed by taxes.
If, instead, the retirement account was a Roth account, the retirement account would only be subject to estate taxes and not Federal and state income taxes. Please note, however, that 12 states (including Nebraska) and the District of Columbia impose a state estate tax.
Conclusion.
For many taxpayers, the original purpose of the traditional retirement accounts still makes sense, that is, they will be in a lower tax bracket during retirement than during their active years. For these taxpayers, a Roth conversion is not the best tax strategy. For taxpayers, however, who expect to be in a higher tax bracket during retirement, or those who wish to pass their retirement accounts to their heirs free of any Federal or state income tax burden, a Roth conversion makes sense. If a taxpayer decides to convert part or all of a traditional retirement account to a Roth account, doing so in a down investment market will lower the out-of-pocket tax burden in the year of conversion.