Roth conversions

Roth IRA conversions can be an important potential tool for implementing a tax efficient retirement plan. At its core, a Roth conversion involves prepaying a deferred tax liability in exchange for tax free growth going forward. Conversions are ideal for people who are in lower tax bracket today than they are likely to be in the future.

Having the ability to pay the tax due on the conversion with after-tax dollars (i.e. cash in a checking/savings account or brokerage account) increases the benefit of the conversion strategy. Furthermore, Roth IRAs do not have minimum distribution requirements (RMDs) during an account owner’s lifetime.

Dan, age 62, is recently retired. He anticipates funding his lifestyle in retirement with income from a pension, other after-tax investments, and eventually Social Security. Dan anticipates being in a higher tax bracket once he starts taking RMDs at age 72, than he is today. Dan decides to convert a portion of his pre-tax IRA assets each year so that by the time he turns 72 he will greatly reduce or eliminate his RMDs. Dan further benefits if he pays the resulting tax on the conversions each year from his bank account rather than from his IRA.

Legislation in response to the global pandemic has suspended the distribution requirement for 2020, presenting a unique opportunity to do a Roth conversion for those already taking RMDs.

Dave, age 74, had a $50,000 distribution requirement from his IRA in 2020 that he no longer has to take. Assuming Dave would remain in the same marginal tax bracket with or without the $50,000 of income, he might decide to make a $50,000 Roth conversion instead. Future growth on the converted assets is now tax-free, and Dave has the same tax bill he would have had if required to take the $50,000 as a taxable distribution.

The recent stock market decline is another reason to consider doing a Roth conversion now. Converting assets at depressed values allows for potentially greater tax-free growth as the market recovers. The timeline for a market recovery is unknown. However, investors who have a positive long-term view of the market (as we certainly do) might consider a conversion sooner rather than later.

Diane has a pre-tax IRA that was worth $1,000,000 on December 31, 2019. The value of her account has since decreased by 10% to $900,000. If she converts the $900,000 to a Roth now, and the value of the account recovers to its previous $1,000,000 mark, Diane would shield $100,000 from future taxes by doing the conversion.

Roth conversions can play an important role in a tax efficient retirement plan. Whether or not a conversion strategy is appropriate depends on your individual situation. A Rockbridge advisor can work with you and your accountant to see if a Roth conversion strategy makes sense for you.