Broker Check

To Convert or Not Convert...

May 17, 2024

In This Edition

We present an abbreviated market summary followed by a deep dive into a topic that seems to be of more interest recently, Roth Conversions.

Market Summary

If you avoided looking at your statement in April, you would have missed that the S&P 500 declined by 5.5% during the month.  The market has fully recovered from the spring slide and is back to all-time highs.  This is largely due to improved corporate earnings expectations and slightly weaker than expected labor market data.  Here are three market takeaways since our last note.

  1. Labor Market Downshifts: Some labor market weakness is welcome in the quest to bring down inflation.  For years the labor market has been drum tight, which generally serves to increase overall consumer demand and prices.  April’s Jobs Report was a sign that demand for labor is cooling.  Both new jobs created, and wage growth undercut expectations.  While the data missed analysts’ outlook, the overall labor market remains more robust than pre-pandemic averages.  The market expects the unemployment rate to increase from the current 3.9% to 4.1% by the end of the year.  If the unemployment rate moves much above 4% this summer, it’s likely the Federal Reserve will make a rate cut in September.
  1. The Power of S&P Earnings: Yet again the S&P 500 exceeded expectations, posting 6.5% earnings growth for the quarter, against an expected 3.75%.  More importantly, expectations for 2024 have been increasing modestly since February.  After several quarters of solid earnings, it’s normal to see some weakness as a “payback” for strength.  Not this year, so far.
  1. Inflation Cooling Slowly: The Consumer Price Index (CPI) moved down to 3.4% in April, from 3.5% in March.  At this point, the cost of shelter and transportation services (car insurance) are the main drivers of elevated readings.  Both areas are expected to moderate over the coming quarters, but the process will be slow and uneven.  This is somewhat due to technicalities in how shelter costs are measured and less about the actual cost consumers experience.  The prices of core goods, ranging from furniture to personal computers, have declined modestly so far this year.

There is weakness on the margin in areas ranging from the labor market to consumer spending and some survey data.  A little softening of the economic data is what investors need to be confident that inflation will continue to moderate and allow the Fed to cut interest rates later this year. Overall, the economy is strong, and we appear to be moving further into an environment that is favorable to both equities and fixed income.

Roth Conversions

In recent months, clients have inquired about “Roth Conversions” with increasing frequency.  This provides the opportunity to take a close look at the strategy and posit general guidance on when it is potentially most appropriate.  We’ll begin with a summary of the most common retirement account types.

Common Retirement Accounts:

  • 401(k), a company sponsored retirement account that receives pre-tax contributions from employee participants and pre-tax matching contributions from employers, both within statutory annual limits. Grows tax deferred.  Distributions are taxed as income.  Subject to RMD.  Penalties for withdrawal prior to age 55 (must be separated from service to access at age 55).
  • 403(b), very similar to a 401(k) and typically used by non-profit organizations such as charities, academic institutions, hospitals, etc. Subject to RMD.  Penalties for withdrawal prior to age 55 (must be separated from service to access at age 55).
  • Individual Retirement Account (IRA), an account owned by a person, into which is deposited: 1) individual contributions that are deducted from income for tax purposes, (when possible, based upon income limitations), 2) individual contributions not deducted from income for tax purposes, less common but done when annual income exceeds statutory limits, 3) “Rollover” money from employer retirement plan accounts. Growth of IRA assets is tax-deferred.  Distributions are taxed as income.  There are annual limits to how much can be contributed.  Subject to RMD.  Penalties for withdrawal prior to age 59 ½.   
  • Roth IRA, funded by individual contributions that are not tax-deductible. Grows tax free. Distributions tax free.  There are limits to both how much can be contributed annually and who can contribute (which is limited by income).  The original account owner is not subject to RMD.  Possible/ partial penalties for withdrawal prior to age 59 ½ and prior to 5 years from account opening.
    • Roth 401(k) and 403(b). These accounts are not common but are becoming more so as employers adopt this option alongside their traditional 401(k) and 403(b) plans.  These accounts are funded with after-tax dollars and may receive employer match.  If so, employees must pay tax on the employer match, which is held in a separate account.  For our purposes today, the only thing to know about these accounts is that they may be rolled into a regular Roth at retirement/ separation from service. 

Taxation During Accumulation:

401(k) and 403(b) accounts receive contributions from an employee, and from the sponsoring employer, before those dollars are ever taxed.  Growth in the account is not taxed as it occurs.  Dividends and interest generated by investments in the account are not taxed as they occur.  What starts out in the early years of employment as a modest account can grow to being worth hundreds of thousands, or even millions of dollars by retirement.  Part of what supports this growth is that nothing has ever been taxed – not the contributions, not appreciation in the value of investments, not dividends or interest.

IRA accounts are funded by rollovers from employer-sponsored retirement plans and by account owners directly.  Account owner direct contributions are made with after-tax net income dollars, but the amount of the contribution is typically deducted from income for income tax purposes.  The net result is that dollars in an IRA are usually the same as in a 401(k) or 403(b), which is to say “pre-tax”.  Those whose income exceeds certain limits cannot make a deductible contribution to an IRA and therefore have the option of making a non-deductible contribution.  Non-deductible IRA contributions come with certain tracking and aggregation complexities that are beyond our primary topic but worth mentioning.   

Taxation During Distribution:

Things change when you enter retirement.  Every dollar distributed from 401(k), 403(b) and IRA accounts is taxed as income.  You can’t take distributions from an IRA before age 59 ½ without penalty.  You can take distributions from a 401(k)/ 403(b) at age 55 without penalty (when separated from service).  At age 73, the government forces a certain amount of annual distribution (RMD) so that it can collect taxes on money that has never been taxed.  (Note: on very rare occasions, we have seen after-tax dollars in certain TIAA 403(b) plans, in which case, the after-tax principal contribution is not taxed at distribution).

The Roth IRA Difference:

Roth IRAs are funded with after-tax, net income dollars.  The amount of the contribution is not deducted from income for income tax purposes. 

  • Roth IRAs grow tax free.
  • Distributions are tax free, and
  • Roth IRAs have no RMD for the original account owner.

The Roth IRA is probably the single greatest savings vehicle ever invented.  There are some rules and limitations worth noting.

  1. While distributions from a Roth IRA are income tax free, a portion of distributions taken before age 59 ½ may be subject to penalty and income tax.
  2. A portion of distributions from a Roth IRA may be subject to a penalty and income tax if the account is less than five years old.
  3. You can always take a distribution of your contributed capital without tax or penalty.
  4. If you file income tax as a single person, you can make a full Roth IRA contribution for 2024 if you have modified adjusted gross income (MAGI) of less than $146,000. If you have MAGI of greater than $161,000, you can’t make any Roth IRA contribution.  If your income is between the boundaries, you can make a partial contribution.
  5. If you file income tax “married, filing jointly”, you can make a full Roth IRA contribution for 2024 if total MAGI is less than $230,000. If MAGI is greater than $240,000, you can’t make any Roth IRA contribution.  If your income is between the boundaries, you can make a partial contribution. 

Note:  We are intentionally avoiding discussion of the characteristics of retirement accounts after the passing of the original owner.  This is a topic best discussed by itself.  Suffice it to say that no matter who you are, inheriting a Roth IRA is generally more favorable than inheriting any other type of retirement account.

Roth Conversions:

Clearly, there are significant benefits to Roth IRAs that are not present in other retirement account types.  Ideally all retirement account assets would reside in a Roth account.  If this is so obvious, then why isn’t it the case?  There are, perhaps, several reasons.

  1. Roth IRA accounts were created by the Taxpayer Relief Act of 1997. It may have taken some years for the public to become aware. 
  2. Income limits prevent contributions.
  3. Contribution limits.
  4. As contributions are made with net, after-tax dollars, perhaps consumers didn’t have sufficient free cash flow or willingness to save more.
  5. Roth 401(k) and 403(b) accounts are a fairly recent addition to employer retirement plans and are not yet widely available.

There now seems to be a general awareness and understanding of the value of Roth IRAs and an increasing desire to build a significant Roth IRA balance, by whatever means available. 

One way is to “convert” assets from a traditional IRA to a Roth IRA.  Here are the steps.

  1. Identify the IRA and Roth IRA that will be the origination point and destination point of the asset transfer.
  2. Determine the amount of the transfer, keeping in mind that income tax will be owed on the amount leaving the traditional IRA (as if you were taking this amount as a distribution to yourself).
  3. Decide the percent of federal tax withholding you wish to apply to the transfer, from zero to whatever you like.
    1. Choose zero tax withholding if you have the financial resources outside of retirement accounts to handle the tax or have perhaps overpaid tax elsewhere throughout the year.
  4. Contact PIM for paperwork and facilitation.

Roth conversions add to taxable income, so optimal timing is usually the period between retirement and RMD.  To illustrate, here is the 2024 IRS income tax table for “married filing jointly”.  Clearly, it would be better to pay a marginal rate of 10-12% versus 22%+ on dollars converted to a Roth IRA.

Taxable Income

Base Tax

Plus

Marginal Rate

Of Amount Over

0-$23,200

$0

+

10%

 

$23,201-$94,300

$2,320

+

12%

$23,200

$94,301-$201,050

$10,852

+

22%

$94,300

$201,051-$383,900

$34,337

+

24%

$201,050

$383,901-$487,450

$78,221

+

32%

$383,900

$487,451-$731,200

$111,357

+

35%

$487,500

Over $731,200

$196,669.50

+

37%

$731,200

 

NOTE:  There is a strategy called “Backdoor Roth Conversion”.  This approach is taken by those wishing to fund a Roth IRA but who have income that exceeds the threshold.  Generally, it involves making a non-deductible contribution to a regular IRA then immediately converting that amount into a Roth IRA.  There’s more involved however, and it essentially requires that the originating IRA hold only non-deductible, after-tax contributions, so we will go no further for now.

Why does it matter which marginal rate is applied to the conversion?  Because the more paid in tax on the conversion, the more growth must be achieved by the Roth to recover dollars lost to taxes. 

Which brings us back to the issue of timing.  We suggested above that an optimal time to engage in Roth conversions is the period between retirement and RMD, when taxable income is lower.  However, there is also wisdom in doing Roth conversions when much younger, almost regardless of the tax consequences.  This is because doing Roth conversions in your 30s, 40s, even 50s, provides a longer period of time for growth to offset taxes paid on the conversion, followed by years or decades of growth beyond the break-even point.

Additional points to remember when considering the timing of Roth conversions. 

  1. Each Roth conversion has its own five-year holding period, even if the Roth account is five or more years old, and even if you are 59 ½ or older.
  2. Roth conversions do not count towards meeting RMD. Further, if you are subject to RMD and do a Roth conversion, RMD must be fully satisfied before the conversion transaction can take place.  For example, if you meet RMD via monthly retirement account distributions throughout the year, and decide in March to do a Roth conversion, you will have to take April-December RMD in a lump sum first.  There may be compelling reasons to do this.  But generally, if you are subject to RMD, doing a Roth conversion in November or December probably makes more sense.
  3. Finally on timing, a Roth conversion is deemed to have been completed as of January 1st of the year in which it is completed, no matter when the conversion transaction actually takes place. In the preceding example, a Roth conversion completed in December gets the full year of credit towards meeting the five-year requirement for that conversion.

Closing Comments:

Whether or not a Roth conversion strategy is right for you depends on your unique circumstances, as determined with the assistance of your tax professional and your PIM financial advisor.  Your tax professional is integral to the process of projecting future income, the associated taxation, and working with you to determine how/ when taxes should be paid.  Your PIM financial advisor can use our financial planning tools to illustrate the long-term impact of conversions on taxation, asset growth and retirement cash flow.  Our administrative professionals facilitate the transaction.

If you are interested in exploring the idea further, please contact your PIM financial advisor and your tax professional.