Roth Conversions
Market downturns are never fun and can sometimes be terrifying. Savvy investors often invoke Warren Buffet’s 2008 quote to “Be fearful when others are greedy, and be greedy when others are fearful,”i seeking higher returns over time. Converting pre-tax retirement assets to Roth assets takes this a step further, making those returns tax-free!
Tax Equivalency Principle
First, let’s consider the Tax Equivalency Principle. Investors can pay taxes on their income either at the time they earn or later, if saving in a qualified account such as an IRA or 401k, at the time of distribution. The Tax Equivalency Principle states that if an investor’s tax rate is the same at both points in time, then the net, after-tax return will be the same.ii In the rare case that an investor’s tax rates are static for their entire lives then, the Roth provides no benefit. This outcome is unlikely for most.
Let’s look at an example: Assume John starts with $10,000 in his IRA. He pays 25% income tax.
Scenario A - No Conversion
After a market decline, his investments are now worth $8,000. He decides to “hold on” and after a 25% increase from the market low, his investments are now worth $10,000 again. When he distributes his $10,000 from his IRA, he’ll owe $2,500 in income tax and his net, after-tax funds will be $7,500.
Scenario B - Conversion
Instead of just “holding on”, John instead converts his IRA to a Roth. At the time of conversion, he’ll owe $2,000 in income tax ($8,000 x 25%) and will now have $6,000 in his Roth IRA. After a 25% increase from the market low, his investments are now worth $7,500. When he distributes, he’ll owe $0 in income tax so his net, after-tax funds will be $7,500.
Why Roth Assets Are So Valuable - Regardless of the Tax Equivalency Principle
Benefits of Roth accounts include income tax free distributions, no mandatory required minimum distributions, income tax free beneficiary distributions, Social Security benefit taxation protections, and Medicare IRMAA level protections.
Tax-Deferred Growth and Income Tax-Free Distribution
Investments in a Traditional IRA grow tax deferred. Capital Gains taxes and Dividend taxes are also deferred. However, when funds are distributed from a Traditional IRA, they are taxed as income—even long-term capital gains and income! If you’re in the 24% income tax bracket, instead of paying 15% on long-term capital gains and dividends, you’ll pay 24%!
Investments in a non-qualified investment account also grow tax deferred. Capital gains taxes are paid only when investments are sold, and gains are recognized. Taxes on dividends are paid when dividends are earned. So while the non-qualified account can be more tax-efficient than a Traditional IRA, the Roth account is even MORE tax-efficient.
No Required Minimum Distributions
The benefits of the Traditional IRA start to end with Required Minimum Distributions (RMD). Depending upon when an investor is born, an investor must begin distributing assets from their Traditional IRA at a certain age. Mandatory distributions continue every year until the investor passes away. Recall distributions from Traditional IRAs are taxed as income at the investor’s current tax rate.
Roth IRAs do NOT have required distributions. So regardless of age, the Roth investor can continue to enjoy tax deferred growth for their entire lives!
Tax Free Distributions for Beneficiaries
Generally, beneficiaries of Traditional IRAs must distribute the inherited IRA over their lifetime or within a 10 year period after inheritance (for Eligible Designated Beneficiaries (EDB) or Non-Eligible Designated Beneficiaries (NEDB)).iii Consider an adult child (NEDB) beneficiary who inherits an IRA at age 57. She will most likely be in her highest earning years and have retirement savings of her own. The RMDs from her inherited IRA, added to her own family income, can easily push her into a higher income and capital gains tax bracket, along with triggering the Net Investment Income Tax (NIIT) which is another 3.8% tax!
Inherited Roth IRAs have the same required distribution rules for EDBs and NEDBs. However because the distributions are income tax free, they don’t push beneficiaries into a higher income tax bracket and aren’t included in Modified Adjusted Gross Income (MAGI) calculations so they don’t trigger the Net Investment Income Tax!
Social Security Benefit Taxation and Medicare Premiums
Traditional IRA distributions are included in income tax calculations as noted above. The taxation of Social Security benefits is dependent upon reported income—so IRA distributions can increase the percentage of Social Security benefits subject to income tax. Furthermore, Medicare premiums are also calculated based on MAGI and higher incomes can trigger the dreaded Income Related Monthly Adjustment Amount (IRMAA)—increases to Medicare Part B and Part D premiums.
Roth distributions, again, are not included in MAGI calculations, potentially saving investors from paying higher taxes on their Social Security benefits and paying higher premiums on their Medicare benefits. This feature also applies to EDBs and NEDBs taking distributions from inherited Roth IRAs. iv
Convert a Higher Percentage of Assets During a Bear Market
Converting $10,000 to a Roth from a $100,000 IRA is a conversion rate of 10%. If the conversion is done during a market decline, you can convert a higher percentage of assets. Suppose the $100,000 IRA drops to $80,000 and then a $10,000 conversion is accomplished. You’ve now converted 12.5% of assets to a Roth—more of your assets are now highly tax efficient!
Other Considerations
The Roth account has a myriad of positive features but there are some items you should take into consideration before executing a conversion or making a contribution. First, if converting, you will need to have funds available to pay tax on the converted amount. Second, you should pay careful attention to the likelihood of having a lower tax rate in the future. If you realistically expect your tax rate to be lower in the future, it makes sense to utilize the Traditional IRA instead. Third, you should carefully plan so any Roth distributions are “qualified distributions”. There are two separate 5-year rules that come in to play with the Roth IRA.v Finally, you should consider if your beneficiaries are going to be in a lower tax bracket—some investors evaluate the “family” tax plan to include beneficiaries.
WealthBridge Capital Management is ready to help you evaluate your income plan, to include Roth contribution and conversion analyses, Social Security benefit timing, and retirement plan distributions. If you don’t have a retirement income plan, or your need to update or review your current plan, please reach out to us at 614-591-4515 or email us at info@wealthbridgecm.com to schedule an appointment.
i Warren Buffet, “Buy American. I Am”, The New York Times, 17 OCT 2008
ii Ben Henry-Moreland, “Why the Value of a Roth Conversion is Calculated Using (True) Marginal Tax Rates”, www.kitces.com, 26 OCT 2022
iii See IRS Publication 590-B for specific definitions of the classes of beneficiaries
iv WealthBridge Capital Management does not offer tax advice. Please consult your tax professional for information specific to your situation.
v See definitions of qualified distributions in IRS Publication 590-B