Roth IRAs have several tax benefits over pre-tax retirement plans like a 401(k) or a traditional or nondeductible IRA account.

Is your traditional IRA or 401(k) down in value this year? If so, it may be a great time to convert to a Roth IRA. We have been very busy modeling the estimated future values of maintaining a traditional IRA versus converting it to a Roth IRA and performing a proverbial breakeven analysis.

Downturns in the stock market often lead taxpayers to the tried-and-true tax planning strategy of utilizing loss positions to offset realized gains; however, this tax planning technique generally is only available for nonretirement assets and requires taxpayers to reduce positions that may one day regain value.

One potential way to benefit, in the long run, from a down market without sacrificing market share is by converting a traditional IRA or pre-tax 401(k) to a Roth IRA. Unfortunately, this strategy also comes at a tax cost, as the pre-tax plan must be taxed in the year of the conversion. Usually, the entire distribution, including pre-tax contributions and any subsequent earnings, are subject to tax. Then, after the conversion, the Roth account becomes “after tax,” and earnings and contributions are distributed tax-free.

In a down market, like we are currently experiencing, the conversion to a Roth IRA is effectively cheaper than during a booming market. In a bear market, a much greater proportion of the pre-tax account can be converted to a Roth for the same income tax cost as a smaller proportion in a bull market. Then, as the market recovers, the gains and earnings will be shielded from tax in the Roth account.

Roth IRAs have several tax benefits over pre-tax retirement plans like a 401(k) or a traditional or nondeductible IRA account, including:

• After-tax accumulation. Since Roth IRAs grow tax-free and distributions are not subject to tax, the accumulation of earnings power within a Roth IRA is far greater than in pre-tax accounts where a portion of the distribution must be considered for federal and/or state income taxes.
• No required minimum distributions. Unlike a traditional IRA or 401(k), Roth IRA balances are not subject to required minimum distribution rules once a taxpayer reaches the age of 72.
• Tax-free distributions. The earnings portion of a distribution from a pre-tax plan is subject to federal and/or state income tax, while Roth IRA distributions in retirement, or after an individual reaches age 59½, are tax free.
• Estate planning benefits. Any federal/state income taxes paid as a result of a Roth IRA conversion reduce the potential taxable estate of the IRA owner. Additionally, an heir receiving distributions from a traditional IRA may be in a higher tax bracket while they are working. In contrast, if a retiree converts funds from a traditional IRA, the marginal tax rate upon conversion is likely to be lower than that of the future beneficiary. Beneficiaries of Roth IRAs also are able to withdraw the money tax-free.

Usually, Roth IRAs provide taxpayers with more flexibility since distributions are at the taxpayer’s discretion, which provides better opportunities for effective income and estate planning.

Taxpayers who have been consistently contributing to nondeductible IRAs may benefit even more significantly from a Roth conversion since the taxable amount of the conversion would not include the previously taxed “basis” in the nondeductible IRA, thus reducing the tax “hit” on conversion.

In general, the following taxpayers may benefit the most from a Roth conversion:

• Taxpayers who are traditionally in the highest tax bracket. Roth conversions will not force a taxpayer into a higher marginal rate, and with tax rates generally expected to increase in the future, taking advantage of a lower current tax rate coupled with a downturn in the market may be attractive and profitable.
• An individual with favorable tax attributes that need to be consumed, such as charitable deduction carryforwards, investment tax credits and NOLs, among others.
• An individual in a low tax bracket currently, but who expects to be in a higher tax bracket in the future.
• An individual whose estate will owe tax, as the income tax paid in connection with the conversion would reduce the taxable estate.
• An individual who does not need the IRA distributions for living expenses, or expects their spouse to need the funds for living expenses after they pass.
• An individual with favorable tax attributes that need to be consumed, such as a charitable deduction carryforward, investment tax credit, net operating loss, net operating loss carryforward or some other nonrecurring loss in the current year to be used to shelter a portion of the income resulting from the conversion.

An additional consideration, beyond the current state of the stock market, to consider in utilizing a Roth conversion is the ability to offset income from converting with anticipated losses in the current tax year (ordinary trade or business losses, suspended losses from the disposition of a passive activity and/or pairing with a planned increase in itemized deductions). In addition, a potential downside of a Roth conversion is that it may increase modified adjusted gross income for purposes of the net investment income tax (NIIT), subjecting investment income to a 3.8 percent tax. While the conversion will create taxable income, that income would not be subject to the NIIT―however it could effectively subject other investment income to that tax. Further, increasing your adjusted gross income may also mean higher Medicare Part B premiums.

TAG’s Perspective

As with any tax strategy, careful analysis should be performed to determine the cost/benefit in converting a pre-tax plan to a Roth IRA. You should work closely with both your tax adviser and investment adviser to determine whether a Roth IRA conversion is advantageous given your particular facts, circumstances and goals. From modeling estimated future values to analyzing breakeven scenarios, our practitioners are available to assist you.

For More Information

If you would like more information about this topic or your own unique situation, please contact Luke J. Bartlinski, Michael A. Gillen, John I. Frederick, any of the practitioners in the Tax Accounting Group or the practitioner with whom you are regularly in contact. For information about other pertinent tax topics, please visit our publications page.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.