How Tax Reform Changes IRA Conversions

How does tax reform affect the decision to convert a traditional IRA into a Roth IRA?

Tax reform made several changes that might change your decision about whether or not to convert a traditional IRA to a Roth IRA. Before looking at the details, however, let’s consider a broader factor that wasn’t changed.

I’ve frequently recommended tax diversification for individuals. Tax diversification means having investments in accounts that are treated differently under the tax code. You should have assets in taxable accounts, tax-deferred accounts (such as traditional 401(k)s and IRAs), and tax-free accounts (such as Roth IRAs and health savings accounts).

Tax diversification provides protection against changes in the tax law. We can’t forecast what the tax code will be like in the future, but I suspect it will be different from today’s tax code. If most of your assets are in one type of account designed to benefit from today’s tax law, you take the risk that changes in the tax code will punish you. It’s safer to own the different types of accounts. Some will benefit from future changes, while others won’t.

Tax diversification also helps you reduce taxes in retirement by managing your tax bracket. That can increase your after-tax return and make your nest egg last years longer. For details about managing your tax bracket, see our April 2018 issue.

If you don’t have tax diversification, you have a strong reason to consider converting some of your traditional IRA to a Roth IRA.

Tax diversification is not the only potential benefit to convert a traditional IRA to a Roth IRA.

You won’t have to take required minimum distributions (RMDs) after age 70½ from a Roth IRA. Also, distributions from a Roth IRA generally are tax-free. Your beneficiary who inherits the Roth IRA also will receive the distributions tax free. But the beneficiary will have to take RMDs.

Converting a traditional IRA to a Roth IRA comes with a price. The amount converted has to be included in gross income as though it were distributed. You receive the tax benefits of the Roth IRA by paying taxes now instead of later.

To decide whether it makes sense to pay the taxes early, several factors have to be considered and balanced, and you have to make some assumptions about the future. Don’t try to
make an intuitive decision. Use one of the many calculators available or work with a financial professional. Here are the key factors.

• Changes in tax rates. The most important factor usually is the difference between the tax rate on the conversion and the rates in the distribution years. Conversions make the most sense when your tax rate will be the same or higher in the future, though conversions can be profitable in other situations, depending on the other factors.

When considering tax rates, be sure to factor in the potential for future traditional IRA distributions to push you into a higher tax bracket or trigger the Stealth Taxes, such as the Medicare premium surtax, tax on Social Security benefits and net investment income tax. Your marginal tax bracket in retirement might be much higher than the rate in your tax bracket because of these Stealth Taxes.

• Length of the post-conversion period. The longer most of the money stays in the Roth IRA for investment returns to compound, the more you benefit from a conversion.

How conversion taxes are paid. For maximum benefit, the taxes should be paid from non-IRA funds. Otherwise, you have to pay taxes on the money taken out of the IRA to pay the taxes, and that money isn’t in the Roth IRA to compound over time. If you are under age 59½, you’ll also owe the 10% early distribution penalty on that money. (Converted amounts are not subject to the 10% penalty.) Those factors increase the cost of the conversion.

• Amount of conversion taxes. The conversion could push you into a higher tax bracket or trigger Stealth Taxes, decreasing or eliminating the benefits of the conversion. Don’t forget
to consider state income taxes on both ends of the conversion, keeping in mind that some states tax Roth IRA distributions.

• Investment rate of return. The higher the rate of return on the investments, the more sense a conversion makes. If you invest for a low rate of return, the benefits of a conversion
could be reduced or eliminated. Don’t forget the RMD. When you’re age 70½ or older, you need to take the RMD for the year before doing a conversion.

You need to examine all these factors and look at the long-term results from a conversion, not only the cost in the conversion year.

Now, let’s see how the Tax Cuts and Jobs Act affects IRA conversions.

The law made only one direct change in IRA conversions. That change was to prohibit recharacterizations, or reversals, of conversions made after 2017. We discuss that a little more in the next article in this newsletter. The new law also had changes that indirectly affect conversions. These changes are the decrease in tax rates and a higher standard deduction, which can decrease the tax cost of converting an IRA. Another indirect change is that the new tax rates are only temporary. They’re scheduled to revert to the 2017 rates in 2025 and could be increased before that if Congress changes leadership.

The decline in tax rates and increase in the standard deduction mean that for most people an IRA conversion is likely to carry its lowest tax cost ever in 2018. If you
believe tax rates aren’t likely to be lower than they are today and are likely to rise in the future, that’s a factor in favor of paying taxes at today’s rates through a conversion instead of in the future.

Let’s see how these factors balance out using the example of Max and Rosie Profits, who are age 60. Their marginal tax rate in 2018 is 24%. They’re considering converting $50,000 of a traditional IRA to a Roth IRA. They expect that during retirement beginning at age 70 their tax rate will increase to 28%. They’ll earn an 8% pre-tax investment return before retirement and a 6% return after retirement. The tax rate on their taxable accounts will be 15% before and after retirement.

Using a spreadsheet I built to take into account as many factors as possible, the Profits learned the federal taxes on their conversion would be $12,000. At age 70, the Roth IRA would accumulate to $114,423. If they hadn’t done the conversion, at age 70 the traditional IRA would have compounded to $114,423 and the money they would have used to pay the taxes would have been invested and compounded to $24,350. That would be a total of $138,773 from not converting. But that’s a pre-tax amount. In the 28% tax bracket, the traditional IRA is worth only $82,385 after taxes.

Let’s look at the results after a 30-year retirement. The Profits plan to withdraw 4% from their nest egg the first year and increase that by an estimated 3% inflation each year after that.

If the Profits don’t convert, after 30 years the after-tax withdrawals from the traditional IRA plus the side account would total $226,604. The withdrawals from the Roth IRA would amount to $228,858.

That looks like a slight advantage to the Roth IRA. But at that point the after-tax remaining balance of the traditional IRA plus the side account would be $51,936, while the Roth IRA would have $109,785 left. That’s a clear advantage to the conversion.

Now, let’s assume the Profits’ tax rate in retirement is the same 24% it was before retirement. Then, the cumulative after-tax withdrawals from the traditional IRA plus side account
would be $236,893, compared to $228,858 from the Roth IRA if they do the conversion. But the traditional IRA plus the side account would have an after-tax value of only $54,357 compared to $109,785 for the Roth IRA. There’s still an advantage to the conversion, but a less significant one.

Let’s look at one more change.

We’ll reduce the Profits’ expected pre-retirement, after-tax investment return to 6% and their post-retirement, after-tax return to 4%. In that scenario, the Roth IRA has a higher
lifetime after-tax payout: $186,258 compared to $168,796 if they don’t convert. But both options run out of money between ages 98 and 99.

We also can reduce the inflation rate to 2%, and thus reduce the annual increase in retirement withdrawals. Lower inflation is a reasonable assumption if we’re assuming lower investment returns. In that case, after 30 years the Roth IRA would have $17,909 left compared to $14,850 after-tax for the traditional IRA and side account combination. The Roth IRA would have paid out about $13,000 more after-tax in lifetime distributions.

I’m not saying that a conversion makes sense all the time. I’m showing how the different variables change the results of a conversion. For example, higher tax rates in the future would make a conversion now more valuable. High expected investment returns also make a conversion more valuable. Those are the two factors most likely to change the results, but the others also are important. The key is to determine which assumptions you believe are most likely and see if a conversion pays off under those circumstances. Then, see what happens if the assumptions change.

If you don’t have enough tax diversification or are thinking of taking advantage of today’s low tax rates to do a conversion, be sure to consider all the angles. Use one or more IRA
conversion calculators or work with a financial adviser.