Tax-Saving Opportunity

For anyone who has been contemplating converting his retirement account to a Roth account, this could be the time to act.

The reason 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.

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 in many historical periods,” notes Susan Czochara, practice lead of the retirement solutions group at Northern Trust Asset Management. “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.”

She points to the value that tax diversification can add to a retirement portfolio. “Especially for those younger investors who are a long way from retirement, it’s very difficult to anticipate what the tax situation will be when they actually retire,” she says.

An Issue Brief publication 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 vs. pre-taxed assets among U.S. retirees.

“Traditional and Roth individual retirement accounts [IRAs] 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 allow only nondeductible after-tax contributions, and withdrawals are generally not subject to taxation. Further, owners of Roth IRAs are not required to make withdrawals.

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’ll 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 to do the conversion.”

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