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What a Still Lofty Market Means for IRA Conversions

Christine Benz

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Although investors have experienced a bit of volatility recently, stocks have been trending up for the better part of a decade. Joining me to discuss the impact of a still lofty market on IRA conversions is retirement expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back here.

Benz: Let's discuss IRA conversions. First, just the logistics of an IRA conversion. You do owe taxes on the amount that you convert. Let's talk about how to execute a conversion and the implications.

Slott: Right, you're talking about a Roth IRA conversion. So you move it from your IRA or even your 401(k) ...

Benz: Your traditional IRA ...

Slott: Right, to a Roth, and you owe tax on the all the pre-tax funds converted. Now the tax, people always ask this question. What's the amount of tax I pay on that? That's different for everyone. It gets added to your existing income. It will cause a spike on your tax return for that year.

Benz: One thing I've been hearing from investors, and we have had a little bit of volatility recently, but investors have generally seen their balances creep up, up, up in their IRAs, and so question is, is this a bad time to do a conversion because the market has been trending upward for the better part of a decade now?

Slott: Right. What if it falls?

Benz: Exactly.

Slott: Remember, the new rules now which started in 2018, Roth conversions are now permanent. There's no going back. You'd better get it right the first time. Now as far as, is the market too high--you have to look at why you're doing it. You have to look at the long-term results. What do you want to accomplish? You could say well the market's up. I don't know, what if it falls?

But the ups and downs are in the short term. Long term, the market will probably go up, traditionally as it's done. It goes up and down, but in an upwardly direction. So that's good if money is in a Roth IRA growing tax free. You also have to look at the tax rates. Remember, you're looking at what is the tax cost of converting. The market may be up, so you're converting a high value, but it may be at a lower rate compared to the rates we had in the past years. One of the core principles of good tax planning is always try to pay taxes at the lowest rates. If the lowest rates are now, even though they might be on a higher value, long term you may be better off because the market will probably go up and tax rates are more likely to go up in the future.

Benz: You and others have counseled that people ought to consider their partial conversion versus doing one giant conversion. Let's talk about the benefits of doing that.

Slott: Well, if you're worried about converting at the top of the market and then the market takes a tumble for a day or whenever it does and these things happen all the time, maybe to soothe that, maybe do dollar cost averaging into a Roth conversion. In other words, a series of smaller annual conversions over time, leading up to where  your taxable IRA little by little is going down and your tax free Roth is increasing. This way you can manage your tax brackets, keep it at a lower level because remember you can't undo it anymore. You really have to have a good projection of what it's going to cost you. But if you do a little over time, over the years that may be a way to smooth out the tax bill.

Benz: Let's create a little bit of a checklist for people who are thinking about conversions. You noted that one of the key things to think about is you're going to owe taxes so where is that money coming from. If you have to pull the money from the IRA to meet the tax burden, that's not as advantageous.

Slott: That's not a good move. Yes, you have to have the money because again you can't go back. That's got to be the first thing. Do I have the money to pay the extra tax? You also have to figure how much the extra tax might be because once you raise income, other benefits may go away and cause an additional tax. You have a 3.8% tax on net investment income, Social Security, Medicare charges, certain deductions like medical that are tied to a level of adjusted gross income, which is what we're talking about. But again that's a one year spike. You have to still look long term, you have to look at what your rates are that year--maybe you have business losses, maybe choose the time to do the conversion when you think your income may drop.

Benz: A tricky part of this right now is that in 2018 we have a whole set of new tax laws. One of the big outgrowths of the new tax laws is that fewer people will be itemizing their deductions, more of us will be taking the standard deduction. How should people begin to think about the tax burden that would be associated with the IRA conversion?

Slott: You can't compare apples to apples anymore. What people used to do in the past, look at last year's return and this year's return, they are two different tax systems now, as you just said. You just have to focus on the projected amounts for 2018. Now coming into the end of 2018, when people will be watching this and you probably have a lot of your numbers in, maybe it pays to do just a rough estimate. If you're worried about the tax money, where is it going to come from--first, you have to have the money because you can't go back, the tax bill will be owed--then convert less. You know, I would err on the side that their taxes are going to be higher. I have a feeling nobody is really going to know how the tax law affects their 2018 taxes till they actually do the return in 2019.

Benz: That's a tricky element. And then also my age and my proximity to retirement, where I am in the life cycle, that also is in the mix. Let's talk about how people can think about their own situation.

Slott: Right. There are reasons not to do a Roth. Remember this is not for everyone. The idea of getting money into a Roth is because you want tax-free income in retirement, and the other big benefit is no required minimum distributions, which a lot of seniors don't like being forced to take money. But is it wise for somebody, say, over 70 to convert? Not if they are converting for themselves because the upfront tax cost of converting versus their given life expectancy is not worth the benefit in their lifetime. But if on the other hand, they're doing it because the plan is to leave it to children or grandchildren who might stretch it over their lifetimes, then it might be worthwhile. You have to see what your own reason is.

Benz: Does the child or grandchild's income level or expected income level when they begin taking the money out figure in? Should I be comparing my income tax bracket to the kids?

Slott: You can, but you never really know where some kids will end up. What if you have a grandchild who is 5 years old, you don't want to say, he's smart – look he's reading already. I shouldn't say 5, they are reading at 1 now.

Benz: Right. So, don’t necessarily over think that if you have young kids.

Slott: Unless you have somebody, maybe you have a beneficiaries in their 40s they are an executive or a professional, pretty good shot they'll be in a high bracket. Then you'll be doing them a favor converting to a Roth not to add to their tax bracket. Because while they have to take required distributions from an inherited Roth, at least those distributions for an inheritor that might be in a higher bracket will be tax-free.

Benz: Any other key tips that you would offer to people who are mulling conversion?

Slott: Tread lightly make sure you know what you are doing. Like we said you have the money and whatever tax you project add a little on just in case you are off, you didn’t consider all the nuances of how this new law is going to play out. You'll have a better idea next year. But if you want to get the conversion in this year you can't wait till next year. It's not like IRAs; with an IRA contribution you have until April 15 next year to qualify for this year. With a conversion if you want it to account for 2018 the funds have leave the IRA in 2018.

Benz: By the end of the year. This seems like an excellent spot to get some tax advice.

Slott: Oh, yes. Get a good projection.

Benz: Ed thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching I'm Christine Benz from Morningstar.com.