Kevan shares his thoughts on Roth conversions with Tom Taulli of Barron’s
By Tom Taulli
The first half of this year marked the worst performance for the S&P 500 since 1970. With inflation soaring and interest rates rising, the index posted a loss of 20.6%. The dire sentiment may have been overdone. The markets have gone on to stage an impressive rally. Since the June low, the S&P 500 has logged a gain of 17%. A large Roth conversion can push a client into a higher tax bracket. Partial conversions are a popular way to avoid this problem. Yet there are still many portfolios that have significant losses, especially those heavily weighted in high-growth tech and biotech sectors. For the year so far, the ARK Innovation ETF (ARKK) is off about 47%— even though, since mid-June, the fund has rallied 38%. There are some strategies to help clients with investment losses. One is a Roth conversion. This is where you transfer assets from a retirement account—like a traditional IRA, 401(k) or 403(b)—to a Roth IRA. “A big benefit of doing Roth conversion after a large pullback is that it’s almost like you are getting a Roth IRA on sale or at a discount,” said Ashton Lawrence, a financial advisor and partner at Goldfinch Wealth Management.
But there are other important advantages. Here is a look:
– Tax benefits. Suppose your client has a traditional IRA with $100,000 in pretax funds. At a 32% tax bracket, the tax bill would be $32,000 on a Roth conversion. However, if the value of the portfolio drops to $70,000, then the tax owed would be $22,400—for a savings of $9,600. This could be higher if the client drops to a lower bracket. “By taxing those funds today and holding those assets until age 59 ½—barring a few notable exceptions—there will be no tax on future withdrawals, no 10% penalty and no required minimum distributions at age 72,” said Eric Thompson, a director and wealth advisor at Round Table Wealth Management.
– Brackets. A Roth conversion generally makes sense if your taxes will increase in the future. Keep in mind that the Tax Cuts and Jobs Act is set to expire by the end of 2025. This means that the tax brackets will return to the levels before Congress passed the legislation. For example, the 24% bracket will return to 28%, the 32% rate will go to 33%, and the 37% bracket will become 39.6%. The law retained the old structure of seven individual income tax brackets, but in most cases, it lowered the rates. The top rate fell from 39.6% to 37%, while the 33% bracket dropped to 32%, the 28% bracket to 24%, the 25% bracket to 22%, and the 15% bracket to 12%. You also need to factor in state taxes. If a client moves to another state, there may be no income tax. “Planners can utilize software that factors in both tax rates and investment returns along with the taxpayer’s age to aid in the planning and provide insight to the taxpayer,” said Larry Harris, the Director of Tax with Parsec Financial.
– Partial conversions. This is a popular strategy. The reason is that a large Roth conversion can push a client into a higher tax bracket. “Those in the 24% tax bracket should be especially careful with this because the next bracket up is 32%, which equates to an increase of about 33%,” said Kevan Melchiorre, the co-founder and managing partner at Tenet Wealth Partners. “Partial conversions over the course of several years can help spread out this potential tax bite.” A large conversion can also mean paying higher premiums for Medicare Part B and D. Part A covers hospitalization and home health care while Part B is for doctor services, outpatient care, and medical equipment purchases. “While it’s not a deal breaker, clients need to be aware of it,” said Catherine Azeles, an investment consultant for Conrad Siegel. A Roth conversion may even impact college funding. Generally, the distribution is factored into the calculation for financial aid.
– Estate planning. The Secure Act (the name is an acronym for Setting Every Community Up for Retirement Enhancement) requires non-spousal beneficiaries of inherited traditional IRAs to distribute all funds within ten years. This can mean much higher tax bills. They will be even worse for those beneficiaries who are high-income earners. But with a Roth IRA, there are no taxes due. “For folks that don’t anticipate needing these funds, a Roth Conversion makes a great wealth transfer tool to children and grandchildren,” said Thomas F. Scanlon, a financial advisor at Raymond James Financial Services. “This could translate into decades of tax-free growth.”
Tom Taulli is a freelance writer, author, and former broker. He is also an enrolled agent, which allows him to represent clients before the IRS.