Roth Conversion Financial Advice

Summary

• “Roth rollover” or “Roth conversion” are terms that pop up their heads again and again as the strategy that benefits almost everybody. But, is this really true?
• There is a situation where a Roth IRA conversion is the clear choice and is worth paying the tax upfront to take advantage of its unique benefits. However, in most.
• Please remember that in most cases, having more in a Traditional IRA to grow and compound almost always overrides the other stated technical benefits.

Roth Conversion

It is that time of year again, when tax strategies start coming to the forefront of people’s minds. “Roth rollover” or “Roth conversion” are terms that pop up their heads again and again as the strategy that benefits almost everybody. But, is this really true? Is it really always beneficial? At what point is a rollover or conversion advantageous and when is it better to just keep things the way they are (meaning keep the traditional IRA)? Look no further than below to find the answers to these titillating questions!

A 401K, IRA and Roth IRA are all tax advantaged (or qualified) accounts where dividend income and capital gains are not taxed while growing. (For this discussion, I will call both a 401K and an IRA, an IRA, because they work the same way; they are just regulated differently.) Let’s compare taxable versus non-taxable accounts. Let’s say you have a $1M dollar stock portfolio in a non-tax qualified account. Typically, the taxable dividends will be about 2% of the portfolio. [1] Let’s say you did some trading that resulted in another 2% short-term gain. You would be paying tax on $40,000 as if it was regular income. After federal and state tax, your liability would be roughly 14K ~ 18K in tax. The result would be similar even if you had some investments in fixed income assets. With an IRA or Roth, there won’t be any tax liabilities as long as they are in the account. So, the tax benefit is clear when comparing a non-qualified account versus an IRA or Roth. Now the big question comes: Do either of the two IRAs have an advantage over the other?

There is a situation where a Roth IRA conversion is the clear choice and is worth paying the tax upfront to take advantage of its unique benefits. However, in most circumstances, a Roth conversion is not for most. In fact, we think “Roth conversion” is a hyped marketing term. Marketing materials with Roth conversion themes are frequently designed by big investment and insurance product companies to get high net worth investors’ attention, making them feel that they might be missing something big in their tax strategy. Due to complexity of calculation involved in deciding if a Roth conversion is beneficial, an unverifiable justification with a “trust the experts” mindset is typically given.

Here is a simple comparison between Traditional, Roth converted, and Regular non-qualified accounts for 60-year-old Anna who has $1M in the account. Let me use one of the most common scenarios: She will retire at 65 and start withdrawing funds from the account at a reasonably sustainable level of $30K per year to supplement social security income. Assume an inflation rate of 2.5%, an investment return of 5.5%, and tax rates at 25% Fed and 9% State throughout.

As shown in the chart above with the account values,

First, when converting to a Roth IRA, Anne has to pay full tax upfront. That immediately reduces the entire balance by about 34%, leaving much less investment to grow and compound.

Second, more withdrawals need to be made from a Traditional IRA than a Roth or Non-Tax Qualified account, because tax needs to be paid upon withdrawal. However, the larger investment balance left to grow easily offsets the higher withdrawal needs resulting in much higher investment balance.

Third, one proponent of Roth conversions says that not having to deal with the Required Minimum Distribution of a Traditional IRA is the prime advantage of a Roth IRA. However, that advantage needs to be carefully evaluated along with other factors to conclude if it is an advantage holistically.

Two situations where a Roth conversion might be beneficial include:

1. Young workers who expect their income to exceed the income threshold in the future especially during the retirement years, such as doctors and rapidly rising young executives.
2. Older generations who want to pass on their wealth to the next generation without burdening the heirs with the distribution tax. This strategy may not work all the time depending on a specific situation.

However, please remember that in most cases, having more in a Traditional IRA to grow and compound almost always overrides the other stated technical benefits. In my opinion, Roth conversions have been widely promoted by investment product companies and Internal Revenue Service, who stand to monetarily benefit from the transaction. An IRA must be liquidated to cash and tax withheld first. Then the remaining assets need to be reinvested in, usually, new mutual funds, new annuities, etc. All opportunities for more commission.

[1] The long-term average is about 4.3% (S&P 500 Dividend Yield). So, it could get a lot higher in the future.

[2] It is based on the most likely or typical scenario for middle upper middle-class Americans living in MN. Tax amount may vary significantly depending on your other financial and income matters.

Sarah & Ujae Kang

UAK Diversified Wealth Management