The Benefits of Roth Conversions

By The Chicago Partners Team

April 24, 2020

Estimated Reading Time: 8 minutes

The Benefits of Roth Conversions

The past month has been a very tumultuous time for the market. Many of us are seeing the values of our portfolios drop. It is an uncomfortable time to be an investor.

Even in these uncomfortable times, we can find unique opportunities to improve our wealth management strategies. One of these strategies is the Roth Conversion.

A Roth Conversion is moving some assets from a taxable retirement account, like an IRA, into a Roth IRA, which is a non-taxable retirement account. Because a Roth is funded with after-tax monies, qualified withdrawals from a Roth are treated as non-taxable events. In other words, income from a Roth withdrawal will not be taxed, unlike withdrawals from taxable IRAs (like an RMD).

One note here is performing a Roth Conversion requires a withdrawal from a taxable retirement account, which counts as income in the year it was withdrawn, and is considered a taxable event.

I have put together a group of illustrations that show four scenarios where a Roth Conversion can be a smart strategic move to optimize your wealth.

Scenario 1: Depressed Market Values

Image

The first scenario shows an opportunity to save money on taxes through a Roth Conversion by moving securities that have lost some market value into a Roth IRA.

In normal market conditions, the cost of a Roth Conversion is equal to the taxes paid from the distribution from the taxable retirement account. We see in this example that the cost of a Roth Conversion is $2,000 (assuming a 20% tax rate). So, an investor would withdraw the money, pay the associated taxes with the withdrawal in the tax year it was taken, and move the money into a Roth IRA.

However, when the market value of the securities in the IRA has declined, a Roth Conversion can take advantage of the lower market value to reduce the taxes associated with the conversion. If we assume that the market has dropped 30%, and we perform the same Roth Conversion, we see tax savings of 30% ($300 in this case).

By moving securities affected by a market decline into a Roth IRA, we save money on taxes, and retain the same value of the securities after the market recovers.

Scenario 2: Reduce Future RMDs & Taxable Income

Image

In this scenario, we look at the value of a Roth Conversion ten years in the future, and how the conversion will affect future RMD’s.

Without a Roth Conversion, a 5% RMD of $10,000 (at the same 20% tax rate) will cost $2,000 in taxes ten years in the future.

However, by converting some of the traditional IRA into a Roth IRA, we can avoid some of the taxes from the future RMD. A 10% conversion reduces the future value of the RMD by reallocating assets to the Roth IRA. When the RMD comes around in the future, the distribution is less than it would have been without a Roth Conversion, reducing the taxes owed on the RMD. Meanwhile, the securities in the Roth account have been growing tax-free.

Performing a Roth Conversion ahead of RMDs can reduce the amount of taxes an investor has to pay while creating a tax-free subset of assets in the Roth account.

Scenario 3: Reduce Future Taxes Even More with Higher Future Tax Rates

Image

If we are anticipating future tax rate increases, then performing a Roth Conversion now can reduce the impact of the higher future tax rates.

In the case there is no Roth Conversion, the full amount of the RMD will be taxed at the higher future tax rate (30% in this case, up from 20%). The cost of taxes is $3,000.

Again, in the case of the Roth Conversion, the taxes on the future RMD are reduced. And here, performing a Roth Conversion early gives the benefit of using the current tax rates to pay for the taxes on the distribution instead of higher tax rates in the future.

The result is the same as Scenario 2 - the taxes owed on the RMD are reduced.

Scenario 4: Optimizing Roth Investments

Image

After performing a Roth Conversion, the investor now has two groups of retirement assets: the money in the IRA and the money in the Roth IRA. Using a strategic rebalancing approach to harness the benefits of the non-taxable Roth IRA can increase the amount of tax-free income while reducing the income and taxes from RMDs.

If we assume the right portfolio for this investor is a 60% allocation to stocks and a 40% allocation to bonds, then this 60/40 would be split between the two retirement accounts. While a solid strategy, we can use the Roth IRA benefits here to optimize this portfolio strategy.

If we shift the IRA to a 60% bond allocation and the Roth to an 80% stock allocation, then we can expect the total yield from the two accounts to remain roughly the same. However, because the responsibility for portfolio growth has been shifted to the Roth, we can expect the IRA to grow more slowly, and, as a consequence, require smaller RMD’s in the future. And with the Roth more focused on growth, we can expect more tax-free income from Roth distributions later on.

Ask Your Advisor About a Roth Conversion

The scenarios presented above are a few of the ways a Roth Conversion can be a strategic tool to optimize your wealth management strategy. If you are interested in learning more about whether a Roth Conversion is the right strategy for you, please reach out to us or talk to your current advisor.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.

April 24, 2020

Estimated Reading Time: 8 minutes

The Benefits of Roth Conversions

The past month has been a very tumultuous time for the market. Many of us are seeing the values of our portfolios drop. It is an uncomfortable time to be an investor.

Even in these uncomfortable times, we can find unique opportunities to improve our wealth management strategies. One of these strategies is the Roth Conversion.

A Roth Conversion is moving some assets from a taxable retirement account, like an IRA, into a Roth IRA, which is a non-taxable retirement account. Because a Roth is funded with after-tax monies, qualified withdrawals from a Roth are treated as non-taxable events. In other words, income from a Roth withdrawal will not be taxed, unlike withdrawals from taxable IRAs (like an RMD).

One note here is performing a Roth Conversion requires a withdrawal from a taxable retirement account, which counts as income in the year it was withdrawn, and is considered a taxable event.

I have put together a group of illustrations that show four scenarios where a Roth Conversion can be a smart strategic move to optimize your wealth.

Scenario 1: Depressed Market Values

Image

The first scenario shows an opportunity to save money on taxes through a Roth Conversion by moving securities that have lost some market value into a Roth IRA.

In normal market conditions, the cost of a Roth Conversion is equal to the taxes paid from the distribution from the taxable retirement account. We see in this example that the cost of a Roth Conversion is $2,000 (assuming a 20% tax rate). So, an investor would withdraw the money, pay the associated taxes with the withdrawal in the tax year it was taken, and move the money into a Roth IRA.

However, when the market value of the securities in the IRA has declined, a Roth Conversion can take advantage of the lower market value to reduce the taxes associated with the conversion. If we assume that the market has dropped 30%, and we perform the same Roth Conversion, we see tax savings of 30% ($300 in this case).

By moving securities affected by a market decline into a Roth IRA, we save money on taxes, and retain the same value of the securities after the market recovers.

Scenario 2: Reduce Future RMDs & Taxable Income

Image

In this scenario, we look at the value of a Roth Conversion ten years in the future, and how the conversion will affect future RMD’s.

Without a Roth Conversion, a 5% RMD of $10,000 (at the same 20% tax rate) will cost $2,000 in taxes ten years in the future.

However, by converting some of the traditional IRA into a Roth IRA, we can avoid some of the taxes from the future RMD. A 10% conversion reduces the future value of the RMD by reallocating assets to the Roth IRA. When the RMD comes around in the future, the distribution is less than it would have been without a Roth Conversion, reducing the taxes owed on the RMD. Meanwhile, the securities in the Roth account have been growing tax-free.

Performing a Roth Conversion ahead of RMDs can reduce the amount of taxes an investor has to pay while creating a tax-free subset of assets in the Roth account.

Scenario 3: Reduce Future Taxes Even More with Higher Future Tax Rates

Image

If we are anticipating future tax rate increases, then performing a Roth Conversion now can reduce the impact of the higher future tax rates.

In the case there is no Roth Conversion, the full amount of the RMD will be taxed at the higher future tax rate (30% in this case, up from 20%). The cost of taxes is $3,000.

Again, in the case of the Roth Conversion, the taxes on the future RMD are reduced. And here, performing a Roth Conversion early gives the benefit of using the current tax rates to pay for the taxes on the distribution instead of higher tax rates in the future.

The result is the same as Scenario 2 - the taxes owed on the RMD are reduced.

Scenario 4: Optimizing Roth Investments

Image

After performing a Roth Conversion, the investor now has two groups of retirement assets: the money in the IRA and the money in the Roth IRA. Using a strategic rebalancing approach to harness the benefits of the non-taxable Roth IRA can increase the amount of tax-free income while reducing the income and taxes from RMDs.

If we assume the right portfolio for this investor is a 60% allocation to stocks and a 40% allocation to bonds, then this 60/40 would be split between the two retirement accounts. While a solid strategy, we can use the Roth IRA benefits here to optimize this portfolio strategy.

If we shift the IRA to a 60% bond allocation and the Roth to an 80% stock allocation, then we can expect the total yield from the two accounts to remain roughly the same. However, because the responsibility for portfolio growth has been shifted to the Roth, we can expect the IRA to grow more slowly, and, as a consequence, require smaller RMD’s in the future. And with the Roth more focused on growth, we can expect more tax-free income from Roth distributions later on.

Ask Your Advisor About a Roth Conversion

The scenarios presented above are a few of the ways a Roth Conversion can be a strategic tool to optimize your wealth management strategy. If you are interested in learning more about whether a Roth Conversion is the right strategy for you, please reach out to us or talk to your current advisor.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.