Conventional wisdom suggests that it's better to pay taxes later than earlier, but when picking through their investment options, some income oriented investors may have to turn that conventional wisdom on its head.
Consider the following case study. Dan is 67 years old, and has just retired. Dan has accumulated $1,000,000 in his 401(k) plan with his former employer. Dan also owns several taxable brokerage accounts, one of which contains $1,000,000 of cash from some recent sales of stock in his former employer. Dan confronts two issues at the moment: (1) should Dan roll some or all of his 401(k) account into a Roth IRA; and (2) how should Dan deploy the cash in his taxable brokerage account?
Dan's first step is to step back, and set out his investment objectives and risk preferences. Dan's primary objective is to maximize the amount of after-tax income he can consume each year in retirement, ideally without having to dip into principal. Dan considers himself to be an aggressive investor, but is more comfortable with investments that produce cash flow today, as opposed to investments that offer potential for higher growth in the future.
Based on those objectives and and preferences, Dan decides to invest some portion of his assets into Fiduciary Claymore MLP Opportunity Fund (ticker: FMO), a closed-end fund that offers current distributions yielding approximately 6%. Like direct investments into master limited partnerships, most of the recent distributions from FMO have been treated as a tax-free return of capital, which for a taxable investor gives FMO somewhat of an edge over some other high yielding assets.
Dan has also decided to invest a portion of his wealth into Blackrock Kelso Capital Corporation (ticker: BKCC), a publicly traded business development company. Due, in part, to a recent and sizable slump in its share price, BKCC currently offers an extremely high dividend yield of over 13%. Dan realizes there are several drawbacks to investing in BKCC - first, the dividend this company pays may very well be reduced in the near future, and second, the dividend is subject to ordinary income tax rates, rather than the preferential rates corporate dividends enjoy under current tax law.
Dan now turns to the issue of whether to roll his 401(k) plan into a Roth IRA. The main drawback of doing so would be an acceleration of Dan's income tax liability on this account, and at the moment, Dan is in the highest income tax bracket. For simplicity's sake, let's say his combined Federal, State and local income tax rates would be 50%. The benefit of a Roth IRA, though, is that all future withdrawals from the account would be income tax free.
Just for the sake of illustration, assume that Dan has decided to invest all of his 401(k) and all of the cash in his taxable brokerage account into FMO and BKCC (recognizing, of course, that in the real world, Dan would obviously want to hold a far, far more diversified portfolio).
The first thing Dan decides is that it would make sense to invest his taxable account into FMO, since any distributions from that fund that are treated as a return of capital would be tax-free in that account. If Dan held FMO in his 401(k), however, any withdrawals (whether those withdrawals were made from income or principal) would be fully subject to ordinary income tax. Holding FMO in his taxable account could save Dan 50% on those distributions, going forward. On the other hand, Dan decides that it would make sense to invest his 401(k) into BKCC, since distributions from BKCC would be subject to income tax at ordinary income rates in a taxable account, or if taken as withdrawls from his 401(k) account.
The second thing Dan has to decide, then, is whether to convert the 401(k) into a Roth IRA, or keep it in place. Dan weighs these options in the following way:
Option number one: Dan keeps his 401(k) intact, and begins taking withdrawals immediately. From his taxable account, Dan expects to earn a 6% after-tax yield this year - roughly $60,000 assuming (among other things) that he deploys the entire $1,000,000 into FMO and the distributions from that fund remain constant and are treated as a return of capital. Dan also expects that he could earn $130,000 worth of distributions a year from BKCC (assuming the company continues to keep its dividend rate steady). Dan expects that he would withdraw that entire amount from his 401(k), triggering a 50% income tax liability that would leave him with $65,000 a year. Looking at both accounts together, Dan believes that he could earn distributions that would be worth $125,000 to him after tax.
Option number two: Dan rolls his 401(k) into a Roth IRA, triggering an immediate income tax liability of $500,000. Dan elects not to defer this income tax liability, and decides to pay that full amount using cash from his taxable brokerage account. As a result, Dan is left with $1,000,000 in his newly created Roth IRA, and $500,000 in his taxable brokerage account. Dan invests the $500,000 in his taxable account into FMO, and assuming an after-tax yield of 6%, expects that he could receive distributions worth $30,000 this year. Dan then invests his Roth IRA into BKCC, and assuming that company's 13% yield remains constant, expects to receive distributions worth $130,000. Unlike distributions from a conventional 401(k), though, distributions to Dan from a Roth IRA would be entirely income tax free. That would leave Dan with a combined after-tax yield of $160,000 from both his taxable account and his Roth IRA - leaving Dan with roughly $35,000 a year extra in his pocket.
After crunching the numbers, it starts to look like conventional wisdom could leave Dan far worse off than he would be if he bit the bullet, converted his 401(k) over to a Roth IRA and accelerated his income tax liability. I've overly simplified Dan's situation and the tax rules and investment considerations Dan would need to work through, but some elements of the case study may be applicable to income oriented investors at or nearing retirement. If nothing else, the main point is that investors cannot effectively weigh the option of converting their retirement assets into a Roth IRA without also considering the specific investment choices they plan to make, and probably cannot make efficient investment choices without considering their options from an income tax planning standpoint.
Disclosure: I am long BKCC, FMO.
Disclaimer: This article does not constitute, and cannot be relied upon as, tax or legal advice. In addition, the author is not an investment advisor, and nothing in this article should be construed as a recommendation regarding specific investments or investment approaches. Investors should consult their tax and investment advisors before making any investment choices and before converting any retirement accounts or making other tax-related decisions.