In the hard work of saving for retirement, it takes years to build nest eggs and carefully maneuver through economic bumps and potholes. In just a few months, COVID-19 and both the government’s and the markets’ reaction to the virus have spurred a rush by savers to move piles of that money into Roth IRAs.
Fidelity Investments, one of the world’s largest asset managers with $7.9 trillion in assets under administration, has seen Roth IRA conversions surge 76% in the first quarter from a year ago, according to a spokesperson for the Boston-based financial services company.
“The Roth is a nearly ideal investment account,” said Chris Chaney, a vice president at Fort Pitt Capital Group in Green Tree. “There are some compelling reasons to do a Roth conversion right now and we are doing quite a few of them for our clients.”
What’s driving people to move funds they’d built up in traditional retirement accounts to the tax-free retirement accounts?
Part of it has to do with Roth IRA conversions being more valuable when the stock market is down because less taxes would be owed on a traditional IRA with a lower value. But it’s also the belief that taxes may go up in the future as the nation faces up to the piles of debt the U.S. is taking on to create stimulus packages to protect the economy from the coronavirus fallout.
“Even before COVID-19, historically speaking, we currently have some of the lowest tax rates in the history of this country,” said Curt Knotick, CEO of Accurate Solutions Group in Butler.
“With ballooning debt, I strongly believe the Trump tax cuts will not be extended past the year 2025. Secondly, with the spending we are currently undertaking due to the shutdown of the economy over COVID-19, that belief is even stronger than it was before.
“So in essence, in my eyes, taxes are on sale now,” he said.
Understanding a Roth
There are a number of factors at play, but to understand what’s happening, first it’s important to understand the nuances of the traditional IRA vs. the Roth IRA.
The most attractive feature of a Roth IRA is that all withdrawals from the account are tax-free, though you do not receive an income tax deduction on contributions.
Contributions to traditional IRAs, on the other hand, typically are deducted from income taxes and are allowed to grow tax-free during the years before retirement. After reaching retirement age, all withdrawals are treated as taxable income.
When a traditional IRA is converted to a Roth, it means the account owner is changing the tax treatment of the retirement fund.
In a conversion, the account owner pays taxes on the assets coming out of the traditional IRA. And when someone does a conversion, they must pay the required taxes from another nonretirement account so that the taxes are not treated as a distribution.
Once the assets from the traditional IRA go into the Roth, they grow and compound tax-free over the years. The big difference is that once the money is in the Roth IRA, it can be withdrawn tax-free when the investor retires. Withdrawals from traditional IRAs are taxed at the account owner’s ordinary income tax rate.
No one-size-fits-all
Despite the advantages, the decision to convert is not always a simple one.
“This can be tricky. It’s a great idea and can be a great tax benefit, but it sometimes is like threading a needle. If you don’t get the thread through the eye, then what good is it?” said Nancy Skeans, CEO of Schneider Downs Wealth Management Advisors, Downtown.
“If we can facilitate a Roth conversion for a client, we do so after projecting the time it takes to first break even using reasonable assumptions.”
Ms. Skeans said there are two costs to a conversion. The first is the tax that one has to pay to do the conversion. That is the easy calculation.
The second is the lost earnings from the dollars that one has to pay in tax.
“Let’s say that I convert $100,000 from my IRA to a Roth and my tax cost is $25,000,” she said. “In order to break even, I have to overcome the tax cost with growth in my new Roth. But there is a second dollar amount that I must overcome, too. That is the earnings on the $25,000 that I sent to the government in tax dollars.”
What if it takes 10 to 15 years to break even?
That seems like a long time. But Ms. Skeans points to the decade of the 2000s as an example of when the S&P 500 barely provided any return over the 10-year period from 2000 to 2009 due to the Tech Bubble and the Great Recession.
And when it comes to calculating the tax cost of a Roth conversion, you can’t always just simply refer to the tax table.
“I actually did a calculation for a client, and guess what? She and her partner are one of the few couples I know who are currently not paying tax on their annual capital gains because of their income,” Ms. Skeans said. “They actually fall into the 0% tax on their gains.
“When I looked at a Roth conversion, the added income from the conversion was taxed, and guess what? Their 0% tax on capital gains jumped to 15%.”
She said this also happens when you have a retired couple who are not paying tax on some or all of their Social Security income. A Roth conversion adds income to the tax return and suddenly they pay tax on the conversion plus tax on up to 85% of their Social Security income.
“Oh, and don’t forget how Medicare Part B premiums are calculated,” she said. “They, too, are based on income. Although not a lot of dollars, if you are 65 and do a conversion, you may find yourself and your partner, if married, paying the max premium for at least a year.”
Higher taxes ahead?
Wealth managers are worried that taxes will have nowhere to go but up to pay for the growing federal budget deficit that has been made even bigger by trillions being spent on coronavirus relief efforts.
Because of that, many are encouraging their clients to do Roth conversions before the window of opportunity closes.
“It makes sense to consider a Roth conversion on the basis of a potential tax increase alone,” said David Root, CEO of the Downtown-based wealth management firm DBR & Co. “Tax rates now are as low as they’ve been for a long time. That is likely to change. We’re seeing a significant rise in the budget deficit. How do we pay for all this debt?”
The Tax Cuts and Jobs Act, which went into effect in 2018, dramatically reduced taxes for many Americans.
A married couple filing jointly was paying a 33% rate on taxable income from $233,351 up to $416,700 prior to 2018. The tax rate for married couples dropped to 24% on taxable income between $168,401 and $321,450 afterwards.
But the so-called Trump tax cuts are set to expire in 2025. Congress will have to vote to either extend the lower tax rates or revert to the previous higher tax rates. The financial services industry is betting on higher rates being the more likely scenario in five years.
Rule changes
Even if the cost of converting a traditional IRA to a Roth IRA makes sense, then the question could be who are you doing the conversion for?
Someone 40 years old could be making the move to accumulate tax-free retirement savings, which means they would have 2½ decades to break even, grow the account value and then have hopefully another two or more decades to reap the benefits.
But what about a person in their 70s?
The recently passed Coronavirus Aid Relief and Economic Security, or CARES, act has temporarily suspended the required minimum distribution that people age 72 and older are required to withdraw from traditional IRAs this year.
Some are using the tax savings to do a Roth IRA conversion.
What if their plan is not to use the funds for themselves, but instead leave the retirement account funds to a grandchild? Effective Jan. 1, the government changed the rules on inherited IRAs.
The Secure Act eliminated a provision that allowed nonspousal heirs to stretch withdrawals from traditional IRA and Roth IRAs over the course of their expected lifetime. Spouses are still allowed to make withdrawals over their lifetime. But nonspouses — say children or grandchildren — who inherit the accounts must deplete them over 10 years after the death of the original owner.
“If you are doing the conversion not for yourself but for someone else,” Ms. Skeans said, “the time that they have to enjoy the tax-free growth has been chopped off at the knees thanks to the Secure Act.”