- An investor might want to convert traditional IRA balances to Roth to move from a taxable account to a tax-free account when tax rates and even values might be lower.
- A Roth IRA can be "on sale" in two ways: low tax rates, which we have now, and you can count on those now; and lower values, which you can't count on as much.
- The best time to start with a Roth IRA is early in retirement planning, and investors should keep all the documentation.
Christine Benz: Hi, I'm Christine Benz from Morningstar. As many portfolio balances have fallen so far in 2022, the buzz has grown around converting traditional IRA balances to Roth. Joining me to discuss what you need to know before embarking on conversions is tax and retirement planning specialist Ed Slott.
Ed, thank you so much for being here.
Ed Slott: Great to be here talking about my favorite subject--Roth conversions. I love it.
Benz: The Roth IRAs.
Slott: I love tax-free.
Benz: Let's talk about why someone might want to convert traditional IRA balances to Roth.
Slott: To move from a taxable account to a tax-free account when tax rates and even values might be lower.
Benz: Required minimum distributions, you can also get around them if you convert traditional IRA balances to Roth, right?
Slott: Right. It's great. You take control of your tax planning. That's what it comes down to. Once the funds are in a Roth IRA, they're not only growing income-tax-free for the rest of your life, and even after the Secure Act, 10 years after that for your beneficiaries. But as you said, there are no lifetime required minimum distributions, which means you never have to take that money out. And even if you do, if you have qualified distributions, in other words, you've held it for the five years and 59.5, all of those distributions will be income-tax-free. So, you never have to worry about the risk of what future higher tax rates could do to your standard of living in retirement. Because if you don't convert, the problem doesn't go away. Some people think the problem goes away. Well, if I don't convert, I save money because I don't have to pay the tax on the conversion, but the IRA still grows, and at some point, you'll be on, what I call, the government plan where RMDs start at 72 and then you don't have the control of your tax rate that you might have with the Roth.
Benz: There is a tax bill due when you do a conversion. But the fact that many balances are a little bit depressed here in 2022, that embellishes the case for making conversions in a year like this one. Can you walk us through that?
Slott: Yes. There's no question, the Roth is the best single retirement account to own. The only question is how much you're willing to pay for it. So, if it's on sale, that's a good deal. What do I mean by on sale? Two ways: low tax rates, which we have now, and you can count on those now, and lower values, which you can't count on as much. I've had clients over the years who tried to time the market with Roth conversions. Roth conversions are a long-term strategy. Yes, the market gets volatile, goes up and down and up and down, but eventually it goes up. So, you'll probably do well whenever you buy. But if there's a big drop, and you can take advantage? Of course. But I've had clients over the years that tried to do exactly that. One day there's a big drop, and they tried to get the order in. And by the time the order was processed for the conversion, it went right back up. You know what I mean? You see those days where the market goes down 800 points, and it goes up a 1,000 the next day. Very hard to get an order in that quickly.
Benz: We've had a lot of days like that recently. While we're on the topic of potential issues to bear in mind when you're doing these conversions, are there any situations that come to mind where someone absolutely should not convert traditional IRA balances to Roth?
Slott: It's all about the tax rates. That's all it is. It's one big giant bet on today's rates versus future rates. If you think your future tax rates will be higher, then the Roth will pay off long term. Now, many retirees believe, well, there's no point in converting because I'm totally convinced my future tax rate will be zero when my income stops, when I retire. But I found that not to be the case for most people. In fact, I've had clients over the years, we sit down for the taxes, they said, "Ed, how can this be? My income is higher than my best working years." Yes, because you didn't do conversions like I told you all those years, and now the IRA grew and grew, and now your RMDs are higher than your salary. Plus, there's another thing that people don't think of when they project out what their future tax rate will be--the loss of deductions. They're no longer putting in 401(k), or contributing, no longer getting deductions there. No tax benefits for dependent children anymore. Most of them have paid off their mortgage, so there's no mortgage-interest deduction. State and local taxes are limited to $10,000. Most of them are taking the standard deduction. So, that combination of what may be higher income and lower deductions can push more people who think they might be in a lower tax bracket in the future in retirement, and they won't be, and then taxes will be higher, mainly due to RMDs. The larger your IRA is, the larger those taxable RMDs will be.
But some people, if they want to use their IRA, say, for charitable planning, for qualified charitable distributions if they qualify, they have to be 70.5, you don't want to convert that money because that money is coming out at 0% tax rate. You want to make sure you're getting your money out at the lowest possible tax rates, which for many might be now. But there are people that maybe shouldn't convert, either they're convinced that future tax rates may truly be lower, or maybe they have high medical bills, too, that could generate huge deductions. Well, if the only money available might be in an IRA, you might not want to convert that. You may want to take that down to pay those medical bills and at least have an offsetting deduction. So, there are situations. But I think for most people, especially the ones with larger IRAs, given the Secure Act limitation on the back end to beneficiaries to 10 years, most people are more likely to do better with a Roth conversion even if they think they will be in a lower tax bracket in retirement, I'm not seeing that with large IRA balances.
Benz: I wanted to ask are there any life stages that lend themselves particularly well to doing these conversions anytime in people's lives where they should be thinking hard about converting?
Slott: Yes, absolutely. The younger you are, the better. The younger you are, the more likely it is tax rates will increase during your lifetime. Because now, like I said, we're in historic low tax rates. And everybody complaints about taxes. But these are the good old days. These are the lowest rates most people will ever see in their lifetime. Young people also have another advantage. The greatest money-making asset anybody can possess is time, and young people have more of it, and they can capitalize on it.
This to me is a slam dunk, a no-brainer. Any young person starting in the workforce will probably be at their low brackets starting out should only be doing a Roth 401(k) if available at work and their own Roth IRA. To start digging in other than to get, say, a company match and having a deductible contribution, those deductions are not worth as much. You want deductions when your tax rates are higher, and you want to push income in when your tax rates are lower. They have a huge advantage, young people, to start out building an absolutely tax-free retirement fund. We never had that opportunity until recently when the accounts were already built up, and now you have to pay to get a Roth IRA by doing a conversion. So, young people should only be doing that.
Benz: Let's talk about the documentation that one needs to keep. If you've done the conversion, what do you need to save to prove that you have converted the assets from traditional to Roth?
Slott: Well, that's all reported. You go to any of the fund companies, you put it in as a conversion. It's reported everywhere--in the 1099s, on the 5498. So, that's all matched up. But you should keep your own documentation. You get that year-end statement from the brokerage that gives the transactions. So, always keep that forever, really. It's only a few pages. Or keep it on your computer like I do. I download the statement. I have it there forever. And that gives you documentation on when you convert it, especially if you're thinking of dipping in before the five years and 59.5, you'd have to prove when you opened your first Roth. Everybody should try and get a Roth open, either a contribution or a conversion even for a few dollars just to get the five-year clock started. Once you have it for five years and you're 59.5, everything that comes out of that Roth IRA for the rest of your life and 10 years beyond will be income-tax-free. So, get it started early and keep, again, all the documentation, plus keep the year-end brokerage statements that will have that information, the 1099 reporting.
Benz: So, that's right. You do get a 1099. It's essentially like you took a distribution from that IRA, but you need to file that 1099 as well.
Slott: No, you don't file the 1099. That's what you use for your backup. That 1099 is your reporting form, but a copy goes to IRS. You report it on your regular tax return as a Roth conversion. If you're using a computer program like most people do, there's always a little box "amount converted," and it shows it as a taxable distribution, but it proves it went to a Roth, and it shows up on your return as a Roth conversion. And you keep that, keep your own tax returns to show when you did Roth conversions when you started. Now, once you have the five years and 59.5, you don't even need that. Everything is in the Roth as long as you can prove when you first started it. Everything that comes out of the Roth will be totally tax-free. People get hung up. We do these advisor training programs, and the biggest questions we get are on these five-year rules and at the end, at some point, we have to stop the advice and say, look, if your clients are using these Roth IRAs for the way they're intended in retirement, you don't have to know any of this. Five years, 59.5, everything comes out tax-free.
Benz: OK, Ed, always great to get your insights. And I know you love Roth IRAs. It's great to talk to you today.
Slott: Thanks, because I love anything tax-free.
Benz: Thanks so much for watching. I'm Christine Benz for Morningstar.com.
Watch “5 Strategies for Portfolio Withdrawals in 2022″ for more from Christine Benz.