With all of the negative headlines and uncertainty impacting the stock and bond markets so far this year, it can be difficult to see the “forest through the trees” or imagine a time when what’s going on today is history. Eventually, what’s going on today will pass and the trend of the markets providing positive returns over the longer investment time periods will play itself out. A 20 – 40-year retirement is a long time and falls into this category.
Range of stock, bond and blended total returns
Annual total returns, 1950 – 2021
As we’ve written during periods of market volatility, it’s best to keep focused on those things that we can control and try not to get too caught up in that which we cannot, like the day-to-day or short-term movements of the markets.
With asset prices down today, retirement savers and those who are near or in the early years of retirement perhaps in a lower tax bracket, the upside to doing Roth IRA conversions could be significant.
The reason is because, with asset prices down, the income taxes due on a conversion to Roth IRAs are also lower and there’s greater potential for asset growth and withdrawals later on in life that are tax-free.
For savers who’ve accumulated significant assets in traditional IRAs and 401(k)s, these will be subject to required minimum distributions starting at age 72 under current law, which typically results in increasing a retirees taxable income.
Roth IRAs are not subject to required minimum distributions and, as a result, Roth IRAs can help minimize income taxes and surcharges, such as Medicare Part B and Part D premiums, that rise as your income does. This can be particularly important for a surviving spouse who ends up in a more compressed tax bracket as a single-filer (aka the ‘widow’s penalty’).
Roth IRAs are also much more valuable legacy assets for your non-spouse heirs. Under current law, both traditional and Roth IRAs must be emptied within 10 years, however, any non-spouse heirs (children/grandchildren) will owe taxes on the traditional IRA assets they inherit while any Roth IRA assets they inherit will be tax-free. How would you prefer to be remembered in this context?
Unlike Roth IRA contributions, there are no income limitations on Roth IRA conversions. The dollar amount of any pre-tax/deductible contributions and growth that you convert from a traditional IRA to a Roth IRA is considered taxable income at the federal and state level (depending on the state and your overall income). You’ll want to pay any income taxes due with cash you have outside of your IRA to keep as much your retirement assets growing on a tax-deferred basis.
So Roth IRA conversions are not for everyone.
The basic rule of thumb is that, if you think that the tax rate you’ll pay today on conversion is lower than the expected rate when the assets would be withdrawn, then a Roth IRA conversion will likely pay off. If you think that the rate at conversion is higher than the expected rate at withdrawal, then it might not.
You may rightly assume that your income tax rate will be lower when you initially retire and your earned income ends, but keep in mind the IRA required minimum distributions that will eventually increase your taxable income (and your tax rate) starting at age 72 and, again, the tax rate a surviving spouse may have to pay on those required minimum distributions as they increase over time when they are filing singly.
This is where a cash flow projection, which is a standard part of the financial planning provided by ACM Wealth, can be really valuable. It can help provide clarity on what your income and tax rate may be out in the future and it can also reaffirm, despite the uncertainty in the markets today, that your plan remains on track.
Please note that this commentary is not meant to be a comprehensive review of Roth IRA conversions and you should discuss your particular situation with your ACM Wealth Advisor.