ROTH IRA Conversions
As we approach the end of a turbulent year in the markets, we look forward to turning the page to 2023. The volatility of the stock and bond markets in 2022 have created a busier end-of-year than normal for us as we make necessary adjustments to client portfolios and take advantage of some planning opportunities. These strategies end up being a “silver lining” to down markets and often involve some tax planning. We have been very busy performing tax-loss harvesting for clients with after-tax accounts in order to provide tax savings. For clients with fee-based accounts, this is something that we take a look at automatically and process as it makes sense.
Another strategy that receives a lot of attention and we’ve mentioned in a few different places is ROTH conversions. I’d like to focus this newsletter on the strategy to provide some more information for consideration for our clients. A ROTH conversion involves converting some funds from a Traditional IRA to a ROTH IRA. The strategy is a choice to pay taxes now in exchange for tax-free growth and access to tax-free income in the future. From a timing standpoint, it makes the most sense to consider ROTH conversions when markets are down and/or taxable income is down. When markets are down, the thought is to pay taxes now on funds at a discounted value and let those funds recover their value in a tax-free account. When taxable income is down, perhaps in a year someone is in a job transition or early on in retirement, the thought is to pay taxes in a lower tax bracket to provide the opportunity to use tax free assets to reduce taxable income in the future. So, with the timing likely making sense based on the markets being down this year, that leaves us with the question of whether or not having tax-free income in the future at the expense of current taxes is good for one’s long-term financial plan.
Attached below is a good article from Putnam which covers ROTH conversions and other ROTH IRA strategies.
Investor Education: 10 Roth strategies to hedge the risk of higher taxes (putnam.com)
I’ll reference one statement in particular from the document which speaks to some benefits of ROTH accounts as follows. “ROTH accounts can offer certain tax advantages, such as providing tax-free income in retirement without required minimum distributions for the account owner. ROTH income is also not considered part of the income calculation when determining the taxation of Social Security benefits, or if higher Medicare premiums apply.” These are some of the benefits of having access to tax-free income from ROTH IRAs. The other larger and connected reason is to provide a hedge against the potential of higher future taxes.
As I mention to most clients when discussing ROTH IRAs, retirees are likely to experience numerous tax environments over the course of the potential 20-30+ years in retirement. In light of current high levels of government spending and deficit levels, one common question is what will happen to future tax rates. If we had that crystal ball, we would be able to look at future tax rates and perform the mathematical equations to determine whether a given ROTH conversion would make sense. My best guess is that tax rates will go up to some extent in the future. After all, current tax rates are low historically speaking. The real kicker to me is the ability to use tax-free income from ROTHs to strategically lower taxable income and thus the taxation of Social Security benefits as well as keeping Medicare Part B premiums low. I have numerous clients with healthy retirement budgets that are able to receive all of their Social Security benefits tax-free based on the ability to use tax-free income to support some of their budget.
There are certainly cases when ROTH conversions do not make sense; but with timing on our side currently with markets down and the many potential benefits of tax-free income in the future, I think now is a great time to at least perform the analysis on an individual basis. The timing piece will remain on our side until markets recover from the decreases this year. Finally, it often makes sense to consider conversions on an annual basis as we typically try to keep the conversion from causing taxable income to creep far into the next tax bracket. So, if a conversion doesn’t make sense for someone now, that opportunity may still exist in 2023. One final piece of consideration is that taxes due on ROTH conversions can not be withheld. They have to be paid from resources outside of the ROTH along with other taxes due at the time taxes are filed.
I’ve been discussing the ROTH conversion strategy in many review meetings. Please reach out to me if you would like to discuss this within your plan and feel free to share this planning opportunity with friends and family. I close in wishing happy holidays to you and your family.