March 5, 2020

One more reason you may want to convert to a Roth

Last week I wrote an article, Seven Reasons to Fund a Roth, on some of the reasons a taxpayer would consider rolling retirement funds into Roth accounts. Just after the article was posted, global stock markets subsequently endured their worst week in over a decade — giving me reason to amend my prior post, as the drop in stock valuations has made converting IRA funds to Roth funds less expensive than it was a week ago. If you believe the market is in a short-term correction and that equity prices will recover, you may want to consider funding a Roth.

Consider an Oregon resident with an IRA worth $1 million on February 1, 2020. Let’s assume our hypothetical taxpayer is married and her family earns $100,000 this year in taxable income between Social Security, pensions, investment income, and some real estate rentals. If she rolled her IRA to a Roth in early February 2020, the household would have ended 2020 with a taxable income of $1.1 million. Of this $1.1 million, $477,950 would have been taxed at the highest taxable rate (37% Federal and 9.9%), for a combined rate of 46.9%.

If the same investor waited until after the 10% correction to make the Roth conversion, than the math would be a bit different, as the IRA is now valued at $900,000, meaning the taxpayer is recognizing $100,000 less in taxable income. At the highest marginal rates, this taxpayer has saved $46,900 in taxes. Multiplying your marginal tax rate by the amount your IRA account value has dropped will give you a sense of how much cheaper it may be to roll funds to a Roth now than it was prior to the market correction.

A few additional thoughts: First, Roth conversions only make sense when a taxpayer has funds outside of the IRA available to pay the income taxes. Converting funds and then paying the tax bill from that same IRA does a great deal to reduce or eliminate the tax benefit of doing the conversion in the first place. If you do not have outside cash available to pay the income tax on the conversion, the conversion may not pencil out to your advantage.

Second, IRA-Roth conversions can be done at any age. It is important for taxpayers who are taking required minimum distributions to satisfy those distribution requirements prior to converting dollars into Roth accounts.

Third, Roth conversions often involve navigating a labyrinth of tax rules and paperwork with your fund custodian. Please reach out to our team if we can be of any assistance analyzing and/or processing Roth IRA conversions for you and your family.