The short answer – Yes. Equity portfolios are down 10% on average this year. Would you rather have the recovery come in tax-free accounts that are sheltered from income tax or in tax deferred accounts that owe ordinary income tax when withdrawn down the road? There are many nuances to this and to who would benefit from a Roth Conversion. I have outlined these below.
Should you convert to Roth now?
If you were planning to convert in 2022, and have cash on the sideline to pay the associated tax bill, then yes, I think now is a great time to convert. The S&P 500 is down 12.6% year-to-date. Let’s say it finishes the year flat. Then all that recovery happens in an account that will not be taxed by the government down the road. And if you were to die, your heirs will not be taxed either. Equities have historically returned 10-12% annually. Your goal should be to see as much tax-free growth as possible at these levels, and you get a boost considering the market is 12% “on sale” right now.
I’m also a fan of limiting your lifetime tax bill. If you will be in a higher tax bracket in the future than where you are today, I would certainly consider converting some money to Roth when market pricing is temporarily suppressed.
Who should consider a Roth IRA Conversion?
Individuals in poor health with a looming estate tax bill
Families who plan to leave a legacy to heirs
Business owners with abnormally low taxable income for one year
Anyone who wants to limit their lifetime tax bill
Recent Retirees Should Consider a Roth Conversion
The years between retirement and achieving age 72 are arguably the best time to consider a Roth Conversion. This is because at age 72 you are required to take distributions from your tax-deferred IRA accounts (called Required Minimum Distributions or RMDs). You went from not much income to much more income. Let’s say your IRA balance the year before you turn 72 is $2,000,000. Then your RMD for the following year is ~3.65% of that balance, or ~$73,000.
You’ll want to do a multi-year tax projection and take advantage of this period to do some ‘tax-smoothing’. The idea is that you pay a little bit more early in retirement, but the amount you pay in taxes over your lifetime is much lower. You will look to ‘fill up’ the 10%, 12%, 22%, or 24% tax brackets, so you do not have such a large RMD and subsequent tax hit when age 72 rolls around.
Word of caution: Medicare premiums are calculated based on the prior two years of income. The amount converted is viewed as ordinary income in that year, which could have an adverse effect on your monthly Medicare premium. Customers of mine can expect that this will be anticipated and will be part of our planning.
Individuals in Poor Health With a Looming Estate Tax Bill
The estate and gift tax exemption is currently set at $12.06 million per individual (for year 2022). That means that an individual can leave $12.06 million to one’s heirs without paying a federal estate or gift tax. Anything above that amount is taxed at a steep 40%. You will want to run an analysis to see if converting all or a portion of your IRA balance to Roth makes sense. You could shrink or eliminate your estate tax bill and your heirs will receive part of their inheritance as tax free monies and not monies they have to pay income taxes on. Plus, the inherited Roth IRA can grow tax-free for another ten years.
Families Who Plan to Leave a Legacy to Heirs
Similar to the last group, families who do not foresee tapping into all of their IRA assets, may decide now is a good time to pursue a Roth Conversion. Here’s why: Your heirs have another ten years after from your death of tax-free growth (than you), as Roth IRAs do not require withdrawals until the 10th year after the death of the owner. At a 7% rate of return, this bucket of money doubles in 10 years!
Business Owners With Abnormally Low Taxable Income for One Year
Similar to #1 above, this is another perfect time to consider a Roth Conversion. If your income is low due to a bad year or a net operating loss (NOL) carry forward, then fill up those lower tax brackets (10%, 12%, and 22%) with a Roth Conversion. You’ll end up lowering your lifetime tax bill by paying tax at today’s lower rates. This also applies to any profession with variable income like litigation attorneys, realtors, commissioned sales execs, etc.
Anyone Who Wants to Limit Their Lifetime Tax Bill
Really, anyone? If you think that tax rates are going to be higher in the future, and your income will stay about the same, then arguably, yes. Many say it’s inevitable that tax rates will have to increase in order to pay off $30 trillion in US debt. If that’s the case, the more money in Roth accounts the better.
Schedule a time to see if a Roth Conversion makes sense for you and your family. Check out our process here: https://perkinswa.com/working-with-us.