Update: Roth IRA Converison

By Jonathan Harper on July 22, 2022

As advisors and financial planners, it is our job to introduce new ideas and strategies that can help improve our client’s long-term financial picture. In market downturns, such as this current market environment, many investors may feel cautious to make significant changes to their plan. However, amidst this tumult, an interesting planning opportunity called Roth IRA conversions has surfaced that we feel is worth explaining in more detail.

A quick reminder:

• Traditional IRAs provide for pre-tax contributions to grow tax-free until required taxable distributions must begin at the account owner’s age 72.
• Conversely, Roth IRAs allow investors to contribute after-tax dollars that grow tax-free, and there are no mandatory distributions. There are income limits to investors making direct Roth IRA contributions, phasing out at $144,000 modified adjusted gross income (MAGI) for individuals and $214,000 MAGI for married couples.

A Roth IRA conversion, whereby an investor converts dollars from a traditional IRA to a Roth IRA, allows higher income investors, or those who used to have higher income levels and have now recently retired and/or reduced income, to participate in the long-term tax advantages of a Roth IRA. Ever since the Secure Act of 2019 changed the distribution rules around inherited Traditional IRAs, Roth IRAs have become significantly more attractive. Combine this tax law change with this year’s market sell-off (the S&P 500 is down -16.6% at the time of writing) and Roth IRA conversions continue to make more sense for certain investors. The market’s downturn can be thought of as a discount for new money to be invested in Roth IRAs, where all future appreciation is tax-free.

We like to make the argument that completing Roth IRA conversions is an inter-generational tax arbitrage. An investor will pay income tax, likely somewhere between ~10-35%, in the year of the conversion at their current marginal tax rate. This reduces future required distributions throughout the remainder of the investor’s lifetime, as RMDs are calculated based on Traditional IRA account values at the end of each calendar year. Those converted assets are also never taxed again, even in future generations. Due to the 2019 tax law change referenced above, inheritors of Traditional IRAs are now required to fully distribute Inherited Traditional IRAs within ten years, and those distributions will be taxed at future marginal tax rates, which many tax experts expect to be higher than today’s levels. In essence, this technique may slightly increase an investor’s tax burden now, but greatly smooths out and reduces future tax liability for themselves and their beneficiaries.

Thinking big picture for generations to come, that’s HMA!