A common question I receive from investors is whether they should convert a current IRA to a Roth IRA.  This article will address some of the common benefits and concerns to consider when evaluating this option.  This article in no way should be considered tax advice or investment recommendations.  Any actions taken should be consulted with your tax and investment advisor.

Benefits of Conversion

  • After five years, all gains in a Roth IRA are tax free.
  • Current tax rate could be lower than future tax rate.
  • There are no required minimum distributions from a Roth IRA.
  • Inherited Roth IRAs are not subject to RMDs in years one through nine, regardless of deceased age.

Concerns for Conversion

  • Taxes on the amount converted are due for the year of the conversion.
  • Investors must wait five years before gains are tax free.
  • Current tax rate could be higher than future tax rate.
  • Adverse market timing of conversion year.

I would like to give an example of adverse market timing of conversion year.  Let’s assume the investor has their investment in a portfolio which closely matches the S&P 500, or for a better definition, it more closely matches the market.  This is commonly known as asset allocation investing.  For the last two years, this portfolio has done extremely well.  The following is an example of a conversion with assumptions.

Pre-Conversion Assumptions
Portfolio Value $1,000,000
Conversion Date 12/31/2024
Tax Rate Effective (est.) 35%

Post-Conversion Values
Portfolio Value $650,000

 

Let’s assume the market had a 40% correction after the conversion (2008, 2001-2003).  The investors would now have a portfolio worth $390,000.  The investor would have reduced the value of their portfolio by over 60% in one year.  After the 2008 market crash, the market took five years and six months to recover.  If you were a market index investor, you would not have returned to your original conversion value of $650,000 for over five years.

As you can summarize, the key to the conversion is the strategy employed for your investments.

Let me give you an alternative idea to reduce the downside risk of the conversion.

The investor decides to substitute the asset class investment choice with the stock selection style for selecting investments.  The investor then decides to select the top ten stocks each year from the Healthcare sector by market cap.  Their downside in 2008 would have been -13.08% and their portfolio would have fully recovered by December 2009.  In the time it took for the asset class investor (S&P 500 index) to get back to the original value before the crash, the Healthcare stock selection would have made over 50%.

The original conversion value of $650,000 with the asset class selection style would finally be back to $650,000.  The stock selection investor would now have $1,004,584 of tax-free investments.

If you would care to discuss more about these ideas, I am open to visiting with you by phone, in person or by Zoom.

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