Conventional wisdom suggests that conversion of a traditional IRA into a Roth IRA is better for younger individuals in lower tax brackets. The tax cost will be less, and the years of investment growth will be more, than would be the case for an older individual. However, the recent stock market downturn may present an opportunity for older individuals, especially if they have significant IRA balances that could end up being inherited.
For example, if you ended last year with a traditional IRA account balance of $2,000,000, it may have decreased $500,000 by mid-year! History demonstrates that the markets will recover, and, thus, it is likely this unrealized loss will be made up and the account will increase beyond the recovered loss over time. The recovered loss, like all of the distributions from the traditional IRA, will be income taxed upon distribution. But if the amount of that unrealized loss, $500,000, was converted into a Roth IRA in equal amounts of $250,000 over two years, decreased by the applicable income tax (assuming, conservatively, a combined effective rate of 40%), the net, $300,000, and any subsequent growth would, ultimately, be distributed tax free.
Under the SECURES Act, both inherited traditional IRAs and Roth IRAs must be distributed within ten (10) years of the owner’s death. However, the required minimum distribution (RMD) rule does not apply to an inherited account. Prior to withdrawals, the account continues to grow tax free. Assuming, a “wait and hold” strategy to maximize investment growth, the income tax burden upon distribution of the traditional IRA could be significant.
An additional benefit of reducing the traditional IRA balance through partial conversions to a Roth IRA is the smaller RMDs and, thus, less income tax that will result, leaving a larger balance for continued investment.
In the attached example, the $250,000 conversions take place on 8/31/22 and 1/1/23. No growth or loss is calculated on any balance through 12/31/22. With no conversions, the pre-tax Traditional IRA total at the end of ten years is $1,623,525. Applying the 40% effective combined (federal and state) income tax rate, the net benefit totals $974,115. The reduced (post-Roth conversion) Traditional IRA totals $1,081,153, and, after tax, nets $648,692. The Roth IRA total is $537,254 and combines with the reduced Traditional IRA for a total benefit of $1,185,946, which is $211,831 greater than the Traditional IRA’s result, a 21.75% difference!
In sum, this year’s stock market losses may provide a Roth IRA conversion opportunity even for retired account owners who may be taking required minimum distributions from their Traditional IRA. We suggest that you explore this opportunity with your financial advisor and/or tax return preparer.
Click here to download our Excel IRA Conversion Analysis.
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