The coronavirus pandemic and the upcoming election has created a great deal of uncertainty for investors. Income tax, furloughs, and job loss are lingering over the heads of many. As people are navigating these unprecedented times, they are becoming more and more unsure about where to and how much to invest. But it’s important to keep in mind that regardless of uncertainty in the market, it’s always a good time to invest for your future.
The recent stock market meltdown may have dented Americans’ retirement savings, but there’s a silver lining: The downturn made one common retirement strategy less costly for investors.
The strategy, known as a Roth IRA conversion, involves changing a traditional, pre-tax retirement account — such as a 401(k) plan or a qualified individual retirement account — to an after-tax Roth fund. This strategy has some unique benefits when compared with its traditional cousin.
To do the conversion, savers would opt to pay income tax now, while markets are down and tax rates are lower under the Tax Cuts and Jobs Act. Investors who own traditional accounts defer income tax on their savings until withdrawing the money in retirement. Roth savers pay tax up front and don’t pay later. Having at least some Roth funds is beneficial for a few reasons, according to financial advisors. Retirees don’t have to take mandatory withdrawals from Roth accounts, unlike traditional IRA investors, who have to beginning at age 72. Taking Roth distributions could also decrease Social Security taxes and Medicare premiums, which are pegged to one’s taxable income.
In addition, there’s the benefit of tax diversification. Like the concept of investment diversification, tax diversification is important because it reduces the risk associated with unknown future tax rates, advisors said. Data suggest investors aren’t greatly diversifying their retirement accounts from a tax standpoint.
Traditional IRAs held around $7.5 trillion at the end of 2018 — almost 10 times as much as Roth accounts, which had $800 billion, according to the Investment Company Institute. Ultimately, investors should peg a conversion primarily to tax rates — if savers believe their tax rate is lower now than it will be in retirement, a conversion makes sense because it will cost less in the long run, according to tax experts. And, contrary to popular opinion, one’s tax rate doesn’t always fall in retirement, they said.
Tax rates are currently low by historical standards and are likely to increase (rather than fall further) in the future, experts said, given the eventual need to raise federal revenue to reduce the U.S. budget deficit, which is larger as a share of its economy than most other developed countries.
If you are considering a Roth IRA Conversion, please consult with your financial advisor and your EA/CPA or tax preparer to ensure that this decision is the best for your financial situation. If you would like to discuss the potential of a Roth Conversion, please reach out to us and schedule a free 30-minute consultation.