As the year winds down, financial advisers will be asked about the tax and retirement benefits of a Roth conversion. An accurate evaluation should address both the benefits and drawbacks.
This is critical since Roth conversions cannot be undone. The tax law no longer allows recharacterizations of Roth conversions. The tax will be owed.
One of the biggest arguments against doing a Roth conversion is the so-called "opportunity cost." The point argued here is that using funds now to pay the tax upfront on a Roth conversion means losing the future earnings that those funds could have produced — i.e. an opportunity cost. This is simply not true.
It's time to debunk this financial myth. It's important for advisers to explain this to clients and even to CPAs, who will constantly bring this up as a drawback to doing a Roth conversion.
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The No. 1 factor is taxes, meaning the difference between the tax rates paid upfront (now, at the time of conversion) versus the projected tax rates, either later in retirement or for beneficiaries.
If tax rates will be the same or higher in retirement, then a Roth conversion will pay, even though funds will be used upfront to pay the taxes. It's all about the tax rates — not inflation, not earnings and certainly not the opportunity cost. If the tax rates are the same both at conversion and later in retirement, the end financial result will be exactly the same, and this is true regardless of how long the funds are invested before being withdrawn in retirement.
Here's a simple mathematical proof that advisers can use to explain this to clients and tax advisers who may believe that paying taxes upfront will result in a lost financial opportunity.
$100,000 IRA balance; lifetime investment earnings rate is 200%; tax rate of 30%
No Roth conversion — the funds remain in the Traditional IRA
$100,000 after 200% lifetime earnings = $300,000
$300,000 x 30% tax rate = $90,000
Net after-tax balance = $210,000
$30,000 tax paid upfront ($100,000 x 30%)
Net amount converted = $70,000
$70,000 after 200% lifetime earnings = $210,000
In both cases, the net result is exactly the same.
In a Wall Street Journal article in May, Joel Dickson, Vanguard Group's global head of enterprise advice methodology, was asked about whether other factors, like "the length of time the money is invested, or inflation, or investment asset class," affected the decision to go Roth. His response was insistent; "These facts make not an iota of difference."
Bottom line is that it's the taxes now versus later that will be the key factor in determining the ultimate benefit of a Roth conversion.
With taxes right now at all-times lows, it is likely that for most clients, tax rates could be higher in retirement, making the case for a Roth conversion. In addition, unlike traditional IRAs, Roth IRAs have no lifetime required minimum distributions, allowing them to continue accumulating tax-free.
Since future tax rates cannot easily be projected, a smart option might be to do a series of annual partial Roth conversions to hedge against future higher taxes and to provide tax risk diversification.
Each client is different, and a personalized evaluation will be needed. Other factors that should be addressed include the fact that for some clients, taxes may in fact be lower in retirement, which might be a reason not to convert. Or the client may be able to withdraw IRA assets at low or no tax in retirement using qualified charitable distributions or heavy medical deductions, eliminating the need for a Roth conversion for those funds.
Another factor may be to create tax-free benefits for beneficiaries. Even a change in future tax laws might have to be considered, like the proposed SECURE Act. But one worry that can be eliminated is the opportunity cost. It's all about the tax rates.