The Coronavirus Crash Tax Diversification Opportunity

Art by Jonathan Muroya

Susan Czochara is practice lead of the retirement solutions group at Northern Trust Asset Management, a role in which she is responsible for the development and distribution of investment solutions and research content designed for the retirement market.

Czochara sat down recently for a (remote) discussion with PLANADVISER about one of her firm’s most recent analyses, which highlights an important silver lining tied to the market turbulence caused by the ongoing coronavirus pandemic.

“At the time of this conversation, it has been exactly one month since I was last in our office in person, and I was actually the only one on the office floor that day because I had to do something in person,” Czochara recalls. “At the time it was already such a different world we were entering, and over the last month we have continued to see some dramatic swings in the equity markets.”

The swings have been painful for retirement plan investors and individual retirement account (IRA) holders, but one positive note, Czochara says, has been the opportunity to think about getting some tax diversification into one’s investments.

“One of the biggest benefits of consideration of Roth accounts is to create tax diversification in a retirement portfolio,” she explains. “Especially for those younger investors who are a long way from retirement, it’s actually very difficult to anticipate what the tax situation is going to be when they actually retire.”

The common wisdom is that taxes in retirement will be lower because of lower stated income.

“However, if you look at where we are today in terms of where income taxes are, they are lower than many historical periods,” Czochara notes. “In that sense, there is actually a pretty good chance the rates could rise. That fact supports the importance of utilizing Roth in combination with traditional accounts. It helps you prepare for the unknown tax future and to have greater flexibility for future withdrawals.”

The reason why now is probably a good time to do a Roth conversion is the simple fact that asset values are down substantially relative to recent highs. That means the income tax paid on the converted assets will also be substantially lower. Once markets rebound, the assets will then be in a pre-taxed account, meaning they can be drawn tax-free down the road.

An Opportunity Clearly Overlooked

A recent Issue Brief publication penned by Craig Copeland, senior research associate at the Employee Benefit Research Institute (EBRI), offers some informative context for the Roth conversion conversation.

According to Copeland’s analysis, there appears to be relatively little sophistication in the marketplace when it comes to efficiently coordinating the withdrawal of tax-deferred versus pre-taxed assets among U.S. retirees.

“Traditional and Roth individual retirement accounts have different withdrawal and taxation rules,” Copeland observes. “Traditional IRAs can receive deductible or nondeductible contributions, but any gains accrued in the account are taxable at withdrawal at the prevailing income tax rate. In addition, owners of traditional IRAs are required to start making withdrawals once they reach a certain age, generally 72 for those who marked their 70th birthday on July 1, 2019, or later.”

In contrast, Roth IRAs only allow nondeductible after-tax contributions, and withdrawals are generally not subject to taxation. Furthermore, owners of Roth IRAs are not required to make withdrawals.

“Consequently, those owning both IRA types could pursue withdrawal strategies that take advantage of the variations in tax rules—for example, withdrawing from one account type sooner than the other,” he explains.

In reality, the EBRI IRA Database shows, traditional IRAs are clearly the favored source of withdrawals. Copeland says this is true even for those in age cohorts that do not require minimum withdrawals.

“For example, while IRA owners ages 60 to 64 were more likely to use some combination of the IRAs for their withdrawals, they typically only took one withdrawal from their Roth IRA over time, with the remaining withdrawals coming from the traditional IRAs,” Copeland says. “Owners of IRAs with the largest balances who took withdrawals each year within the study were among those least likely to take their withdrawal from a Roth IRA, despite being the individuals likely to have the most to gain from taking withdrawals to minimize taxes.”

EBRI’s analysis shows there was also “little evidence that owners deplete or close one account type before withdrawing from another.” Again, simply put, the account type most likely to be depleted or closed was the traditional IRA.

“Current retirees do not appear to be taking advantage of the different tax regimes of the two IRA types in their withdrawal strategies,” Copeland says. “Instead, they are for the most part preserving their Roth IRAs. … A more widespread understanding that the source of withdrawals taken from IRAs can have an impact on the dollars available for everyday uses could have beneficial effects for many retirees.”

A Lasting Opportunity

The EBRI numbers are somewhat disappointing, but as Czochara observes, the significant market volatility anticipated for the next several months or even years makes this a great time for financial advisers to double down on their tax diversification messaging.

“When account values have dropped, as they have in the first quarter, you will be paying less in income tax on the amount that is converted than you would in normal times,” she says. “That being said, this isn’t an easy strategy for every retirement investor, because there is income tax due when you do the Roth conversion. For many people right now, short-term funding needs are taking precedence, and so it may be a difficult time right now to do the conversion.”

Advisers can therefore take this time to educate their clients about their future conversion opportunity.

“There may be a period some months or years down the road when the stars do align for clients to take advantage of this strategy,” Czochara says. “There is also the opportunity to do partial conversions over a period of several years to help ease the income tax burden. One warning I will conclude with is that, for any investor that is considering a Roth conversion, if you don’t have the liquid cash on hand to pay the income taxes, you really should not tap your existing retirement assets to do it. That is a clear indication that a Roth conversion is not appropriate at this time. You have to plan what assets are going to be available for this strategy.”