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Are IRA Conversions a Good Idea During Volatility?

Pimco's Tim Steffen discusses some considerations to bear in mind before converting.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz for morningstar.com. Amid market volatility, some investors may want to consider converting traditional IRA assets to Roth. Joining me to discuss some considerations to bear in mind before converting is Tim Steffen. He's an advisor education consultant for Pimco. Tim, thank you for being here.

Tim Steffen: Thanks, Christine.

Benz: First, let's discuss why someone would want to consider converting traditional IRA assets to Roth in the first place. What are the big benefits of doing that?

Steffen: You've got to understand that when you're doing a Roth conversion, you're making a bet--you're going to say, "I realize I have to pay some taxes now to do this. But my trade-off for that is I'm going to get some tax-free growth in this account for the rest of my life." So the trade-off is: How much tax am I willing to pay now to get that tax-free growth? And in some cases you don't want to pay more tax now than you certainly would later in life. So you typically see with people who are lower brackets now than they might be later in life. But the whole point is you're willing to pay some taxes now in exchange for tax-free income. And that's the primary thing behind it. Sometimes people will take it to extreme because they say, "Whatever I do, I don't want to pay taxes in retirement, so I'll just pay it all now and be done with it," and that can work, but it's better to be a little bit more surgical than take a shotgun approach to it like that. But Roth conversions can be great for those who are in really low tax brackets now and want to avoid maybe paying taxes at a higher rate later in life.

Benz: And no required minimum distributions on Roths as well.

Steffen: That's the other part of it. Once it's in the Roth, during your lifetime, during your surviving spouse's lifetime, there's never a need to take any money out of that account ever. It can sit in there for the rest of your life. So it can be a really good estate planning tool from that standpoint. You effectively say, "This is money I'm never going to need. I'm going to convert it to a Roth. I'll pay the taxes now on behalf of my heirs, my kids, whoever they may be. They'll never have to pay tax on it." Heirs do have required distribution, they have to take money out of it within certain time periods, and there's some new rules regarding that, but in general, the retiree, the owner, or the spouse never have to touch it if they don't want to.

Benz: Let's talk about why everyone seems to be talking about conversions right now. Is it because the taxes due upon the conversion will be lower because balances are lower? What are some of the themes converging around why now might be a good time to consider conversions?

Steffen: There's really two things that have been driving that. One is a set of laws that were passed back in December of 2019--what we call the SECURE Act--which changed the way beneficiaries are required to take distributions out of retirement accounts that they inherited. Without getting too far into the details, basically beneficiaries in most cases have to liquidate an inherited retirement account within 10 years of the death of the original owner. Which, with large retirement account balance, can mean a significant spike in the taxes for those beneficiaries. So what people have been saying is: Maybe if you're the owner, you're in a lower tax rate than what your heirs will be when they inherit it, why don't you do a conversion? You pay the tax now at a lower rate than what your kids would be in perhaps when they inherit it.

So we came into 2020 with that kind of being the hot topic: Let's look at maybe IRA owners converting and paying the taxes on behalf of their kids so the kids have more money when they inherit it. Then we had the market turmoil that that started back in late February and went throughout March, and people saw their account balances fall, and they started to think, "Now that my account, my IRA, has smaller dollars in it, has less value, should I now consider a conversion?" Which really creates two opportunities. Let's say you were somebody who has always said, "I've got a thousand shares of ABC company stock in my IRA. I was going to convert those to a Roth. Now that thousand shares is worth 80% of what it was a couple of months ago. My tax cost to convert those thousand shares just became a lot less because of the turmoil in the market."
The other side of that would be, "I had planned to convert a thousand shares of ABC. Now I can convert, 1,200 shares or 2,500 or 1,500 shares, whatever the number may be, for roughly the same tax cost that I was willing to pay for the thousand, so when the stock comes back, I've got more shares inside my Roth." If you were somebody who always said, "I was going to convert 50,000," whether old value, new value--your tax cost is going to be same. That's no different. It's just that what you can convert, you can get more shares of something into your Roth now. So when it does turn around, you've got a bigger chance of growth inside that Roth.

Benz: One question that sometimes comes up in the context of conversions is age limits. And obviously, well maybe not obviously, but there are no age limits, but sometimes people wonder, "Well, perhaps I'm too old to convert because I won't necessarily recoup these tax costs that I pay out." So, how should people approach that?

Steffen: Yeah, so with the Roth, as we said earlier, you're making a bet--you are paying taxes upfront earlier than you would otherwise have to. So to offset that front-loading of the taxes, you need years of tax-free growth within the IRA or within the Roth IRA to make up for that. If you're somebody who converts much later in life, life expectancies being what they are, there's less of a chance that you're going to see that account catch up to what it should have been or would have been had you left it in the traditional IRA. Somebody who converts maybe when they're 80 and has a shorter life expectancy, may not be able to see that Roth grow enough to make up for the fact that they front-load with the taxes. Somebody who's younger, in their 50s or 60s or so, has a much greater chance of seeing that Roth exceed the value of what the account would have been.

But again, you have to keep in mind that if you're doing the Roth, part of the reason you're probably doing it is because these are dollars you don't need. So your plan was really to leave it to your heirs anyways. So in that case it may be more of an estate-planning vehicle. You may not personally see the benefit of it in your account, but these were dollars you maybe weren't planning on spending anyway. Your heirs will benefit from it down the road the way the numbers work out in most cases.

Benz: This is clearly a place to get some tax advice, but one strategy that you sometimes hear is that partial conversions can often be advisable--that versus converting a whole IRA balance that maybe you'd want to take it in several increments. Let's talk about the benefits of doing that partial approach.

Steffen: So the one thing you don't want to do is say, "I've got $1 million IRA balance. I'm going to convert the entire thing today. Put me in a bracket that I would never be in otherwise. In a normal year, I would never have income that high. So I'm going to pay a much higher tax rate on that IRA that I ever would had I left." That doesn't make sense to do. Another strategy that people used to do is say, "Well just do a big conversion now and then see how the rest of the tax year goes. Figure out how much you really want to leave in there and then recharacterize the rest, undo that conversion so you get to the right amount that you're willing to pay tax on." Well, that would away a couple of years ago when the TCJA got rid of the whole recharacterization idea.

So now you have to be very careful and tactical about your Roth conversions. And here we are in the first half of 2020. It's been a pretty interesting year in terms of everybody's income. A lot of people don't have any idea what their taxable income is going to look like this year. So they're hesitant to commit to a Roth conversion now without knowing what else is going to be going on in their situation. But they also want to take advantage of the lower market values today. So what you can do is maybe kind of split that in half a little bit and do a little bit of both. Do a smaller conversion now. You might have some idea where your income's going to be--do enough of a conversion to maybe get you close to where you want to be in terms of taxable income.
And then as you get into later in the year, come November, December, you could maybe do any additional conversions to true up or fine tune to get yourself to that income target you're shooting for. So maybe do a smaller one now and then finish it up later in the year. That may be a good strategy for folks who want to do something but aren't sure exactly the right amount.

Benz: Another consideration is the tax bill and where you will get the funds for that tax bill. You say it's really important to make sure that you have the funds external to the IRA, that you don't want to have to take extra from the IRA in terms of your conversion and additional funds to pay the tax bill.

Steffen: When we've run the numbers on this, the best way to maximize the benefit of a Roth is when you take dollars out of the traditional IRA and put them into the Roth--the taxes that are doing that come from other dollars. A taxable account that you've got, a checking account, or something like that. If you have to take money out of the IRA and use those dollars to pay the taxes on the conversion, you don't have enough left to go into the Roth to really get the tax-free growth that you need to justify the conversion.

And if you're under 59 1/2 when you do that, if you take money out of the traditional IRA and it doesn't go to the Roth, you take money out of that to pay taxes, you get hit with a 10% penalty on those dollars, too. So especially for younger converters, you really need to have money out of the IRA to pay the taxes. But even if you're older, the idea is to get as much into that Roth as possible. And if you're taking money out of the IRA, you want it to go to the Roth, pay the taxes with something else. That really makes the numbers work out best.

Benz: Let's talk about this backdoor Roth IRA maneuver. It's a technique that higher-income folks have been using if they've been shut out of direct Roth IRA contributions. That's essentially doing a conversion. Let's talk about that. For 2020, I assume that that's still an option, correct?

Steffen: Yeah, it's still an option as much as it's always been an option. There's been a little bit of concern, Is this really what the IRS intended? No, it clearly was not what they intended when they changed the rules on Roth several years ago, but people have been doing it for a long time now. It's kind of become, "Well, this is the way things are now." So a backdoor Roth conversions have kind have become an accepted thing these days. The idea is if your income is too high to put money directly into a Roth, you put money into a traditional IRA first. Your income's too high to get a deduction for it. So you don't get any tax benefit for putting it in there. That makes it all aftertax dollars in the IRA. You then convert that because you never deducted those dollars to begin with. They're tax-free when they come out, go to the Roth. You effectively get money into the Roth via the traditional, which is, again, not the original intent, but the way it worked out. That could be a great strategy for those who are looking to get money into a Roth IRA but who aren't otherwise eligible. 

There's a big hiccup with that, though, and that is: There's this thing called the pro-rata rule. And it says that if you had any other IRA dollars, traditional IRA, SEP IRA, simple IRA, any of those types of accounts, those dollars have to be considered part of what you're pulling from to do the conversion. So, in other words, you may set up an account, a traditional IRA that holds this now aftertax contribution you're making, plus another IRA that has money from a 401(k) rollover from many years ago, for example. You can't just go to the IRA you put the money into now and say, "These are my aftertax dollars. I'm going to pull these out and put them into the Roth." Mechanically, you can do that, but from a tax standpoint that's not how it works. This pro-rata rule says you have to treat that as if it came partially from that new account you set up and partially from the bigger rollover account that you've got on a pro rata basis. Somebody who's got a large IRA from other contribution sources or a rollover or something like that is going to find the backdoor Roth really isn't going to work for them. It's just not going to provide them the benefit that they might get.

Ideal candidates for a backdoor Roth are those individuals who have never worked. Maybe you're a spouse who's never worked. You've got one spouse who has been the breadwinner all your careers. You don't have a traditional IRA. You'd be an ideal candidate for a backdoor Roth. Or the inverse of that is true. Somebody who has worked at one position all their life and putting money in their 401(k) and never done a rollover and never funded a traditional IRA on your own. That's another great candidate for a backdoor Roth. But if you're somebody who does have your own traditional IRA or SEP or simple, that door's probably not going to be the best strategy for you.

Benz: Tim, it's always great to get your perspective. Thank you so much for being with us today.

Steffen: Thanks again for having me, Christine.

Benz: Thanks for watching. I'm Christine Benz for morningstar.com.