The Coronavirus pandemic is a big fat pile of lemons that life threw at us. Who’s ready for some lemonade?
For all the negatives associated with COVID-19 and corresponding economic shutdowns, the positive is that for many investors there is no better time to take advantage of a Roth IRA conversion. A Roth conversion has the potential to pay big dividends when it comes to growing your tax-sheltered retirement nest egg.
Performing a conversion is a taxable event, however, so being opportunistic about timing is a key factor in pursuing such a strategy. Well, with our current economy a lot of folks will have lower than usual income this year, and that can be exactly the right opportunity to make a move.
This article is the first of a short series, where we will discuss what a Roth conversion is, as well as how to perform such conversions within an existing self-directed IRA or Solo 401(k) retirement plan.
What is a Roth Conversion?
In a conventional tax-deferred 401(k) or IRA retirement plan, you do not pay taxes on money you contribute to the plan. This allows you to put more savings into your plan on the front end. As you invest with your plan, gains are not taxed. This boosts your rate of return and allows you to compound that tax savings over time to exponentially grow your savings.
But, when you take distributions from your IRA or 401(k) in retirement, you are taxed at normal income rates on the amount withdrawn. You end up having more money, and ultimately paying more in taxes on that larger sum. It is still a really big win, but the Roth IRA can be even better.
In a Roth IRA, you pay taxes on the money as you contribute it into the plan. This reduces the amount you place into savings on the front end. However, all growth in value produced by investments over time and future distributions to you from the Roth IRA are tax free.
You pay taxes on the seed, but the full harvest is yours with no loss in value due to taxation.
A Roth conversion is the ability to move value from a currently tax-deferred retirement plan into a Roth IRA. The value converted is considered taxable income in the current tax year but is then switched over to Roth status. From that point forward, the gains in the account grow tax-free.
Evaluating the Payback
Determining whether a Roth conversion will create a positive outcome, meaning more spendable money to you in retirement, is a complex matter. We strongly recommend you discuss any conversion plan with your licensed tax counsel who is familiar with your full financial picture.
It is relatively easy to do a thumbnail sketch of the conversion and determine if there is a likely benefit before you schedule a call with your CPA. There are several calculators on the internet that can help you start your evaluation.
When you perform a conversion, you introduce two costs; the cost of the taxes paid on the conversion and the opportunity cost of future investment returns that cash could have produced.
Keep in mind, you need to have outside savings with which to pay the taxes. To tax a distribution and pay taxes on part of your 401(k) or IRA, to then use that to pay taxes on the converted amount will definitely be a losing proposition.
To effectively compare the non-conversion versus conversion approaches, you need to factor in the loss of cash basis at the starting point. You then need to look at potential investment returns over a period of time and see when the cost of the Roth conversion is recaptured. From that point forward, the Roth will pull ahead and produce more after-tax cash to you.
The following table illustrates the basic framework used to make the comparison.
|Value of tax deferred IRA||Value of Roth IRA|
|Plus income from savings invested
outside of IRA
|N/A, that savings used to pay taxes|
|Less tax on eventual distributions||N/A|
|Equals spendable savings||Equals spendable savings|
Other factors will impact the results such as your current tax rate, any change in rate the conversion will create, the rate of return you can expect, and what your tax rate in retirement is likely to be.
Events such as a lower than normal income year or the availability of tax deductions such as a large amount of depreciation can reduce the up-front cost of making a conversion. This may allow you to make a conversion when you normally could not, or potentially convert a larger amount than might be otherwise possible.
Example 1 – Ross
Ross has done well in his career and has managed to accumulate $1,000,000 in tax deferred savings over the course of 25 years in the hotel business where is he a regional sales director serving multiple properties. He is now in his mid-50’s.
Due to the near complete shutdown of the hospitality industry, he was furloughed in March and expects his normal income of about $225,000 per year will be cut to more like $80,000 to $100,000 this year. That should push his tax bracket from 24% down to 12%. He can easily convert as much as $100,000 of his IRA to Roth status and have most of that fall within the 22% bracket. If he were to convert $200,000, that extra hundred thousand would mostly be taxed at 24%, and that may be more than he wants to bite off at the current time.
Ross has been investing in a private note fund that consistently produces about 11% annual returns.
The scenario Ross is going to evaluate is converting $100,000 to Roth status and seeing where he might stand after 15 years when he turns 70. Following are the results:
|Tax Cost of Conversion||$0||$22,000|
|Plan balance at age 70||$478,459||$478,459|
|Plus income from savings invested outside of IRA||$84,082||$0|
|Less lax on eventual distributions||$105,261||$0|
|Difference||+ $21,179 or 4.6%|
Ross will add a bit more than $21K to his bottom line over a 15-year period. This is enough of a positive to be worth considering, but not exactly a game changer. If Ross were older and had less time for the Roth side of the ledger to pull ahead, this would be a non-starter. Likewise, with a lower rate of return, the differential in the two models might not be as significant.
Example 2 – Crystal
Crystal was just starting to hit her stride in her career in the finance department of a large restaurant chain. Coronavirus pretty much nixed that pathway for her. Fortunately, Crystal has already arranged a new position with similar potential at a regional grocery chain that is going strong even in this economy.
She will have lost 2 months of income for this year, which will drop her from about $80,000 to $68,000. Her husband’s job is stable and the drop in her income does not really change their tax bracket, which is 22%.
Crystal is 32 years old. As a result of the termination from her restaurant job, she has about $50,000 in her prior 401(k) she would like to convert to Roth status and use to make a down payment on a rental house for the IRA. The leveraged income she projects will likely produce about 10% annualized returns on rents, not including any potential appreciation of the property.
Crystal will certainly continue to add savings over time and broaden her investment portfolio, but for purposes of the comparison, she’ll just look at this $50,000 returning 10% until age 59 ½.
|Tax Cost of Conversion||$0||$11,000|
|Plan balance at age 60||$721,050||$721,050|
|Plus income from savings invested outside of IRA||$108,000||$0|
|Less lax on eventual distributions||$158,631||$0|
|Difference||+ $50,631 or 7.6%|
Because Crystal is younger and her Roth IRA capital has a longer time to produce earnings, the benefit of conversion is more pronounced than was the case for Ross. This is true even though her rate of return is a touch lower.
In fact, if Crystal were to put the same 70-year-old end date on her scenario as Ross, the numbers get even more dramatic. Her $50,000 Roth IRA will grow to $1,870,217 and she will see about a $167,000 additional benefit from the Roth conversion!
In our next article we’ll discuss several of the available pathways to achieve a Roth IRA conversion depending on your current plan format and investment holdings.
The information above is educational in nature, and is not intended to be, nor should it be construed as providing tax, legal, or investment advice. Please consult with your licensed tax professional to evaluate a taxable activity such as a Roth conversion.