Elean
Hi everyone. I hope you’re all doing well. This is Elean Mendoza and I’m here with Evan Shorten, the firm’s founder and principal.
Evan
Hello everyone. We hope you’re doing well despite the recent market activity. I know it can be unnerving, but hopefully you’re finding ways to stay sane. I also want to thank everyone who listens to the podcast and is subscribed. Lastly before we begin, I want to ask a favor. If you’re listening and not currently subscribed, I would greatly appreciate it as we’re trying to grow the podcast. Lastly, if you know anyone that might enjoy this content or the information we provide, it would be great if you could forward it to them.
Elean
As you mentioned, it’s been a very rough year for investors with both the S&P500 and DowJones hitting yearly lows twice. The first time was earlier this year in June and most recently at the end of September following the most recent Federal Reserve Funds interest rate hike. Now, no one likes to see the value of their portfolio decline, especially when it’s your nest egg, but with that said, down markets do create a few opportunities from a financial planning perspective. In this episode we’re going to discuss Roth conversions as a viable financial planning strategy for a down market; and in the next few episodes we’ll discuss a few other strategies as well.
Before we get started I want to remind everyone that this is not financial advice and should not be taken as financial advice. While we may be discussing a specific strategy, it does not mean this strategy applies to you, and if you choose to look into the possibility of whether a Roth conversion is right for you, please consult your financial advisor and CPA first.
So with that, let’s start off by doing a quick refresher of what is a Roth conversion.
Evan
A Roth conversion is a retirement strategy focused on moving assets from tax-deferred accounts like a traditional IRA or a qualified employer retirement plan, such as a 401k, into a Roth IRA for the purpose of either maximizing your tax-free income in retirement or to allow your retirement funds to grow without the requirement for minimum distributions or RMDs.
Elean
And why would you need to do a Roth conversion? Why can’t we just open a Roth IRA from the beginning?
Evan
Typically, high income earners are not eligible to contribute to Roth IRAs. For a single filer your ability to contribute to a Roth IRA starts to be phased out at $129,000 in income and at $144,000 in income, a single filer can no longer contribute to a Roth IRA. For married couples filing jointly the phase out begins at $204,000 and at $214,000 contributions are no longer allowed.
Often times, employer sponsored retirement account or traditional IRA are the best retirement savings option for high income earners. However, employer sponsored retirement accounts and traditional IRAs are most often tax-deferred accounts. Meaning, you receive a tax deduction on the contributions you make today, but will eventually have to pay taxes on the income when it’s distributed to you in retirement. With a Roth account you don’t receive a tax deduction on your contributions today, but you’re future retirement income from the Roth IRA will be tax-free once your Roth IRA has been established for at least 5 years and you have reached aged 59 ½.
Elean
Ok, and now why is this a more preferable option?
Evan
First, if you’re not planning on needing or using IRA funds for several decades, there is a good chance you can pay the taxes upfront today and grow your retirement assets to provide you a significant tax-free income in retirement. The reason we sometimes view this as a favorable trade-off is because we’re coming off the lowest tax-rates in history. It’s highly likely that income taxes will be higher in the coming decades as well as many deductions for high-net worth individuals may either be eliminated or reduced.
Another reason we may want to pay the taxes today is to maximize your estate for your heirs, if that is a goal. Because a Roth requires you to pay taxes upfront, the IRS consideres the taxes as having been paid on those assets. As such they don’t require minimum distributions once you reach the age of 72. This allows assets in your Roth IRA to grow undisturbed without having to make withdrawals that would normally slow down the compounding effects of long-term savings.
Elean
In general, Roth IRAs are superior retirement savings vehicles than traditional IRAs for the reasons you mentioned; but what are some of the draw backs of a Roth conversion?
Evan
Death and taxes. Your lifespan and expected use of the funds will dictate if a Roth conversion makes sense for you. Once you move assets from a traditional IRA, or other qualified retirement account, to a Roth IRA the converted dollar amount will be treated as ordinary income tax and could risk pushing you into a higher marginal tax bracket at both the Federal and state level. This happens because you already received a tax-deduction when you first contributed to your retirement accounts and now the IRS wants the taxes it never collected. Essentially, for a Roth conversion to be worth it, you have to live long enough to earn back the taxes paid through the growth in assets and/or income generated by the account. Additionally, it can impact how much you will pay for your Medicare for the following two years before your taxable income drops backs to “normal” levels.
Elean
Ok. So why does a Roth conversion become an attractive financial planning strategy during a down market?
Evan
Simply put, you can convert a greater portion of assets to your Roth IRA for the same tax bill as when financial markets were higher. Let me give you an example to clarify and provide a bit more detail. Suppose you did a Roth conversion of 100 Apple shares back in January of 2022 when the stock was around $182 per share. The total Roth conversion amount would be $18,200. If we assume you’re in the 35% tax bracket you could be looking at a tax bill of $6,370 for converting 100 shares of Apple from your traditional IRA to your Roth IRA.
As of October 21st, 2022 Apple closed at around $147 per share. Today you could convert about 123 Apple shares for the same tax bill of $6,370 allowing you to convert an extra 23 shares than earlier this year.
If markets stay down for a significant period, well into next year, the Roth conversion becomes increasingly more attractive as you can repeat the process without increasing your tax liability from one year to the next. You could convert an amount that your comfortable paying taxes on this year in 2022 and do it again next year in 2023 as opposed to converting one large sum in a single year and substantially increasing your tax liability. Again, any amount you convert will be treated as ordinary income in the current year. As such one popular approach is to convert up to your tax bracket’s limit. Meaning you cap the amount you convert to Roth so that the converted amount does not push you up into the next tax bracket.
Elean
Ok. So while none of us like to see the value of our portfolios decrease, this is one financial planning strategy that takes advantage of a decline in portfolio values to help you increase the value of your tax-free retirement accounts over time. The one caveat with a Roth conversion is time. This is a strategy for a long-term oriented investors.
Hopefully this episode gave you something to think about. While this strategy may not be suitable for everyone it should at least be a reminder that we can still be strategic about our assets even when things get ugly. In the next few episodes we’ll bring you other financial planning strategies that investors could potentially take advantage of during this market decline. In the meantime, please subscribe to the podcast and signup for our emailing list to stay up to date.
Thank you for listening and we’ll see you here next time.
