14 May FA Magazine – Roth Conversion Strategies For A Rocky Market
Recent dips in the market were good opportunities to convert traditional IRAs and 401(k)s to Roth accounts, advisors say. But clients who missed out shouldn’t despair.
“Periods of increased market volatility can present a great opportunity for Roth conversions,” said Bob Alimena, a private wealth advisor at Procyon in Melville, N.Y. “When markets become oversold, it presents the opportunity to convert funds from pre-tax to Roth at a discount, and then allow the future appreciation or bounce back to happen within the Roth.”
Unlike with traditional IRAs and 401(k)s, contributions or conversions to Roth accounts do not give you an immediate tax deduction. But withdrawals from Roths are tax-free, unlike withdrawals from traditional retirement accounts. That’s why advisors say that Roths make the most sense for clients who anticipate being in a higher tax bracket later in life—perhaps because of an inheritance, the sale of a large family home, kids who are no longer tax-deductible dependents or any other reason.
Another advantage of Roths is that they are exempt from required minimum distributions (RMDs), unlike other types of retirement accounts that force policyholders to take out a percentage at age 73 and every year thereafter—and pay income taxes on those amounts. RMDs can also push clients into higher tax brackets, trigger Medicare surcharges and increase the taxable portion of their Social Security benefits. Roth conversions eliminate those costly hassles.
But the conversions themselves are taxable, so advisors say it’s best to do them when your taxes are low—for instance, early in your career or in any year that income dips. The logic is pretty straightforward: Income taxes are due on the total value of converted shares, and when income drops, or those shares are discounted from a market selloff, the tax due is less than it would’ve been otherwise.
In other words, the timing of Roth conversions can make a big difference, said Alimena. For example, if you convert traditional IRA assets when their value drops to $80, you only pay extra income tax on that $80. If the market subsequently recovers and those converted assets appreciate to $100, you end up with $100 in the Roth but only paid taxes on 80% of it, he explained.
He added that clients often have some “gap years,” typically between ending their working career and before turning age 73, that are also ideal for Roth conversions. Taxable income has dropped significantly but required distributions haven’t started yet. In that window of time, he said, the client’s tax bracket is much less than when working full time and lower than it’s expected to be later in retirement.
“When considering Roth conversions for our clients, we run a conversion analysis to identify the optimal years or market conditions to make conversions,” he said.
Follow A Broad Plan
It’s important to follow a broad plan, however, and not just jump into Roth conversions after a steep market sell-off without paying attention to your tax bracket and other factors, advisors say. “Roth conversions can be tricky, if you don’t really know your client’s full tax picture,” said Markham Hawkins of Quotient Wealth Partners in Denver.
Typically, he said, he prefers to do clients’ Roth conversions early in the fourth quarter of the year. By then, he usually has “a good handle on a client’s total income for the year, avoiding surprises like an unexpected inheritance or a large realized gain,” he said.
To avoid having the extra taxable income from a conversion push clients into a higher tax bracket, you need to start by knowing what bracket they’re already in. “To do that, you need to understand all sources of income—dividends, capital gains, even things like deferred compensation or restricted stock units,” he explained, referring to equity compensation that’s promised to employees to incentivize them to stay with the company and share in its growth.
Therefore, while it may be wise to do Roth conversions at depressed values, that isn’t “a blanket recommendation,” as Cameron Rosenow of NorthRock Partners in Raleigh, N.C., put it. “It depends on the client’s broader tax picture and long-term planning goals.”
For him, it’s often best to construct a Roth strategy as part of an annual review, he said, perhaps layering in partial conversions over time as conditions and goals change.
In most cases, advisors designate a dollar amount for clients to convert in any given year, based on each individual situation. The goal is to “fill up” each client’s tax bracket—that is, convert just enough dollars to take full advantage of the client’s current tax bracket, without pushing the client into the next, higher bracket. If that dollar amount happens to convert more shares because the market took a nosedive, that’s just an added benefit, icing on the cake.
Among the other factors to consider, Rosenow cited the client’s age and investment time horizon, since the longer assets are held in Roth accounts the more likely they are to prove beneficial; pending legislation, in case changes in tax laws impact future rates or conversion rules; tax-bracket thresholds, to determine if the client has room to make a conversion without jumping into a higher tax bracket; and whether the client has sufficient cash in a separate account to pay the tax on the conversion.
A further consideration involves estate planning. In general, nonspouse beneficiaries who inherit either traditional or Roth IRAs must empty them within 10 years of the original owner’s death. But during those 10 years, RMDs are due every year from traditional IRAs that are inherited, if either the original account holder or the new one is 73 or older. RMDs are not mandated for inherited Roth accounts.
The Pro Rata Rule
When undertaking Roth conversions, it’s also important to remember the “pro rata rule,” said Jeremiah Winters at Founders Grove Wealth Partners in Richmond, Va., referring to an IRS regulation that says if any portion of a client’s traditional IRAs and 401(k)s were made with after-tax contributions (also called “nonqualified” assets), only the percentage that was pretax (or “qualified”) must be taxed when converted to Roth accounts. So if $100 of IRA assets is converted to a Roth, say, and only 75% of the client’s aggregate assets in traditional IRAs and 401(k)s is “qualified,” then only 75% of the conversion—or $75, in this example—is taxable.
If all of a client’s retirement assets happen to be nonqualified, a Roth conversion is completely tax-free “because taxes have already been paid on these dollars,” he said. That’s “low-hanging fruit for a Roth conversion.” (401(k)s may be more likely than IRAs to have nonqualified assets, because of how contributions are made.)
Given so many potential benefits of Roth conversions, advisors say it’s hard to find a wrong time for them. “I personally don’t believe that anyone can determine the exact [market] bottom or any other perfect time to convert,” said Chad Baxter of Credent Wealth Management in Cincinnati, Ohio.
Don’t wait for the market to go lower, he said, or feel remorse if you think you missed the ideal moment. Instead, he said, focus on “the potential value created by the action that was taken [and] avoid hindsight bias. Any positive action still provides value.”