By Michael Hathaway, CFP®, CFA®, AIF®
More and more, we have been having conversations with clients discussing possible Roth IRA conversions. With very few exceptions, the primary concerns they have with converting tax-deferred dollars out of their IRAs (and those that were previously in their 401(k)s, etc.) center on taxes and wealth:
- I don’t like the idea of paying taxes any sooner than I must, and
- If I pay taxes now to convert, I will be poorer because of those taxes.
Now, I don’t enjoy paying taxes any more than anyone else, but if you could show me that paying $1 of tax today would benefit me by more than $1 in the future, I would at least be willing to listen. And if you could show me that it would benefit me by much more than $1 in the future, present-valued and after taxes and expenses, then I would be very interested.
I believe that a Roth IRA conversion has these characteristics for clients—at least for some clients, some of the time. If we could just help clients get past the idea that paying taxes up front in conjunction with a Roth conversion somehow destroys wealth, I hope that more clients would be willing to consider the benefits of a Roth IRA conversion.
The Burden of Taxes
I believe the biggest problem is how we have been trained to think about our tax-deferred accounts. Let’s start there. Quick, what is the total wealth of the client below?
If you are like most people, you might say $800,000. And you would be partly correct—that is what the statements say (like the ones you get in the mail or download off the internet from your financial institution). However, part of the “story” is missing.
What’s missing is that we have forgotten our “silent partner.” When funds are contributed to any qualified plan (401(k) or 403(b), for example) or a deductible IRA, and the investor/taxpayer gets to exclude those funds from taxable income in the current year, a deal has been made with the “silent partner” that you get to avoid taxation now but will make up for it later. Our (not so) “silent partner” is the taxing authorities: the IRS and any state taxing authority that levies state income taxes (e.g., in California, the Franchise Tax Board).
In the above example, I assumed a combined embedded tax rate of 34% and showed that “actual wealth” is reduced by the embedded tax liability ($136,000) associated with the tax-deferred account (actual wealth of $664,000 vs. $800,000). This tax will eventually be paid. The taxing authorities will not let us withdraw funds from a tax-deferred account without paying taxes at our marginal income tax rates. By the way, in the above example, I am also assuming an after-tax cost basis of $0, so that the entire amount in the account will be taxed upon distribution (withdrawal) at the applicable marginal tax rates.
So, what happens to actual wealth when someone completes a Roth IRA conversion? Let’s assume the client is going to convert $125,000 of her $400,000 balance:
I have included a lot of detail in the above table, but the key is to see that the “actual wealth” hasn’t changed—it is $664,000 both before and after the Roth conversion. So, why do many people think that they are poorer (have lost wealth) after a Roth IRA conversion? I believe it is because they “see” the $42,500 (in this case) in additional taxes they will pay because of the conversion, but they did not “see” the embedded tax liability associated with the tax-deferred account in the first place. All that has happened (with respect to taxes) in this Roth conversion transaction is that a portion of the $136,000 embedded tax liability (associated with the $400,000 statement value of the IRA) was “realized early”—pulled forward into the current tax year. It was going to be paid eventually (you know, the certainty of death and taxes…). We have just moved it up into this tax year. But is this a good idea?
Is a Roth Conversion Worth It?
I believe it is, and I will try to explain the reasoning before showing how the math works. For background, the client above probably didn’t actually contribute $400,000 into the tax-deferred account. Maybe she contributed smaller amounts ($5,000 – $10,000) annually for a number of years, all pre-tax, plus subsequent investment growth, the taxes owed on which are also deferred as long as the funds stay within the tax-deferred account. However, as the money was contributed (pre-tax) and grew (tax-deferred), the embedded tax liability grew right along with it. And if the money is not distributed (withdrawn), the embedded tax liability will continue to grow right along with the growth in the value of the account. (In all fairness, if the account value declines, the embedded tax liability will also decline, but I don’t think any client would consider that a good outcome.)
So, if the embedded tax liability will grow alongside the growth in the tax-deferred account, what can we do? Well, this is where a Roth IRA has distinct advantages not available anywhere else: tax-deferred growth that will never be taxed again. For background, the biggest limitation with Roth IRAs has always been getting money into them; annual contribution limits are low (for 2021, there are per-person limits of $6,000 and $7,000 for those over 50 years old) and are restricted to an income limit and phase out (for 2021, $125,000 for single tax filers and $198,000 for married filing jointly). (1) However, under current tax law enacted in 2010, there is no limit on the amount that can be converted from a traditional IRA to a Roth IRA, and there are no income limits on who can convert. Therefore, any amount can be converted, and any amount that is converted to a Roth IRA can grow without the accompanying tax liability growing along with it.
In the top half of the table below, I show how a single $125,000 Roth IRA conversion can result in higher after-tax/“actual” wealth after five years of growth. In the bottom table, I show the “control group,” or what happens to “actual wealth” without any Roth IRA conversion.
After only five years of growth, the actual wealth of the client who completed a Roth IRA conversion is $13,840 (11.1%) higher than the client who did not. Remember, all investment accounts in the example above are growing at 5.8% annually. The key is that $125,000 has been “liberated” from the parasitic tax liability that is embedded in every tax-deferred account (IRA) and continues to grow right alongside its host. This amount will grow even larger as the amount in the Roth IRA continues to grow, and/or if a larger amount is converted. (If any of the math embedded in the above example seems hard to follow, or if I have skipped some steps, please feel free to reach out to me with any questions or suggestions.)
Need Help With Your Decision?
Finally, while Roth IRA conversions might not be appropriate for every investor in every situation, hopefully I have shown that doing a Roth conversion does not destroy actual wealth at the time of the conversion. In addition, actual wealth can be created from a Roth IRA conversion when the future growth escapes future taxation because it is located within the Roth IRA account type. With apologies to my college chemistry professor (and the First Law of Thermodynamics), real financial advisors can help clients build additional wealth by guiding clients through their understanding of value-added tax planning, estate planning, and modern portfolio theory.
We at Epsilon Financial Group help our clients make sound financial decisions and work through complex financial matters for our clients. If you’re interested in finding out how we can partner with you in your current life stage and beyond, email me at Mike@wealthmatters.com or call (707) 428-5500 to get started.
Disclaimer: This article does not provide specific investment, tax, or legal advice. Please consult your financial, tax, or legal advisor if you wish to understand how a Roth IRA conversion might affect your particulars.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, a Chartered Financial AnalystTM, and an Accredited Investment Fiduciary®; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.