Monday, May 18, 2020
A Timely Revisit of the Roth Conversion
Anthony C. Kure, CFP®

Anthony C. Kure, CFP®

Director of Northeastern Ohio Market, Senior Portfolio Manager, Principal
Wealth Management, Cleveland - Akron

A Timely Revisit of the Roth Conversion

We have yet to reach the halfway point of 2020 and already we’ve endured a decade’s worth of global upheaval, economic pain, and market volatility. After a historic stock-market rebound from the late-March lows, it’s a good time to step back and survey the planning landscape from a more stable vantage point. Uncertainty is still pervasive and will remain for the foreseeable future. Even so, it is prudent to seek opportunities to make the best of these trying circumstances to the extent possible. Events thus far in 2020 have led to one such opportunity – the Roth conversion.

Roth conversions are a tax-arbitrage strategy. It essentially involves making an educated guess that accelerating distributions from the IRA and converting that money to a Roth IRA will lower the collective amount of taxes paid during your lifetime and that of your heirs. By incurring more income than is required and paying the resulting taxes in the current year, the goal is to lower tax bills in the years ahead. There are many factors at play, but in the right circumstances the savings can be substantial. Recent developments in tax law, market values, and government policies could make for more attractive circumstances for Roth conversions in 2020.

Near-Term Tactical Opportunity

  • Roth conversions are more attractive when stock markets are lower. Despite the sharp rebound, U.S. large cap stocks are still roughly 10% below the February high. We don’t engage in market timing, but stocks are likely to continue to grow over the long term. Holding growth investments like stocks in Roth IRAs is particularly attractive because there are no taxes on dividends, interest, or capital gains. In addition, distributions from Roth IRAs are not taxed as income. As a result, converting tax-deferred assets to a Roth and investing in high-growth assets could help maximize account values, provide a tax-free withdrawal bucket for retirement, and ultimately, an attractive account to pass on to heirs.
  • The suspension of required minimum distributions (RMDs) from traditional IRAs in 2020 provides another tactical opportunity. IRA owners in RMD status cannot do Roth conversions until their entire RMD is satisfied. For many, conversions on top of their RMD will push them into higher tax brackets. Now that RMDs have been suspended, an IRA owner can consider whether to convert the first dollars out of the traditional IRA into Roth dollars, incurring the tax liability but ensuring tax-free growth for these funds going forward. The advisability of conversions will depend not only on the tax implications but also the need for the money for living expenses. If IRA distributions combined with other sources of income drive taxable income too high conversions still might not make sense (see “Caution” section below). 2020 may be a limited window to take advantage of this strategy, as RMDs will likely be required again in 2021.

Long-Term Secular Changes?

  • The federal government is borrowing record amounts of cash to triage the economic hemorrhaging brought on by the government-mandated shutdowns. Even without further stimulus packages (which still appear likely), the federal budget deficit could quadruple to $4 trillion dollars in 2020. Total federal debt could exceed 100% of GDP for the first time since World War II. Such deficits and debt levels are likely unsustainable. It’s not a stretch to expect federal and state tax rates to go up to offset this in the years to come. This means today’s tax rates could someday be viewed with nostalgia, making Roth conversions more appealing.
  • In what seems like ancient history now, we must also keep in mind the passage of the SECURE Act in late December 2019. One of the key provisions in this act was to sharply reduce heirs’ ability to “stretch” the withdrawal of their inherited IRAs over their presumably longer life spans, as a result incurring less taxable income. With the new law, heirs’ distributions will now be compressed into a 10-year timeframe, which leads to much larger distributions and tax bills. By converting to a Roth now and paying the tax, heirs would inherit more Roth dollars. Inherited Roth IRAs are still subject to the same 10-year distribution limitation, but the distributions would be tax free.

Proceed with Caution

Roth conversions are attractive for some, but beware of collateral damage that could occur. Converting too much to a Roth and adding too much income could result in unintended damage. Higher taxable income could lead to:

  1. Higher capital gains taxes. Above certain thresholds, the tax rate on capital gains incurred increases from 0% to 15%, or from 15% to 20%. This may be of lesser concern this year given the stock market decline and associated realized losses. 
  2. Increased taxability of Social Security. The amount of Social Security subject to tax can be as high as 85% depending on a taxpayer’s total income, including amounts from a Roth conversion.
  3. Increased Medicare IRMAA (Income-Related Monthly Adjustment Amount) surcharges on Medicare Part B and Part D premiums, which are imposed based on the tax return from two years prior.

If none of these factors are deal breakers, 2020 could be a great opportunity to start or supplement a Roth IRA.