Why No Party for the Roth?
Future tax savings from a Roth IRA often easily offset the immediate tax liability. But, even after 20 years, clients aren’t celebrating this product.
Future tax savings from a Roth IRA often offset the immediate tax liability. But clients aren’t celebrating.
WHEN THE ROTH IRA MARKED ITS 20TH BIRTHDAY on New Year’s Day, the event didn’t trigger nearly as much celebration as it merited.
Over two decades, this product has truly become a key retirement account. Roth accounts have grown to hold more than $660 billion in assets, according to the Investment Company Institute. And yet, as popular as they are, they are still greatly underused. Investments held in Roths totaled only about 8% of the $7.9 trillion that was held in IRAS overall at the end of 2016, according to the ICI.
This huge disparity exists in large part because big-dollar rollovers from employer-sponsored qualified retirement plans, which can involve millions of dollars, are made overwhelmingly into traditional IRAS, not Roths.
Roth IRAS, instead, remain funded predominantly by smaller contributions, which currently cannot exceed $5,500 annually for most investors and $6,500 for those who are age 50 and older.
CLIENTS COULD BENEFIT, BUT DON’T
In 2015, 85% of newly opened traditional IRAS were funded solely by rollovers, versus only 15% for new Roth IRAS, according to the ICI. During the nine years from 2007 through 2015, only 6.9% of Roth investors at the end of 2015 had made rollovers into their Roth IRAS.
These facts suggest that many clients who could benefit from doing a Roth conversion are failing to do so. Why? The likely answer is they are deterred by the immediate tax liability that results when you convert pretax savings in a qualified plan to post-tax savings in a Roth IRA.
Yet for many of these clients, the future tax savings from a Roth — perpetual tax-free distributions in retirement — plus greater planning flexibility under Roth rules would more than offset the immediate tax liability. Planners who can advise clients on conversions can provide great benefits to both those clients and their own practices.
In many ways, the Roth IRA was created as a mirror image to traditional IRAS. To begin, contributions to traditional IRAS are generally deductible and distributions from them are taxable at ordinary rates, whereas with Roths, it’s the reverse: Contributions are nondeductible, but distributions in retirement are tax-free.
Consider a simple case, in which an IRA owner remains in the same tax bracket throughout her life. In this scenario, a traditional IRA and a Roth will lead to the same after-tax result. But in reality, most people will not stay in the same tax brackets as they age. People tend to be in lower tax brackets early in their careers, and in higher ones later. In this situation, the Roth IRA can produce large tax savings.
Roth IRAS also differ from traditional IRAS in their treatment of long-term capital gains. When such gains are distributed from traditional IRAS, they are taxed at ordinary tax rates, not the long-term capital gain rate, which is lower. This makes traditional IRAS inferior to taxable accounts. But Roth IRAS provide higher after-tax returns than taxable accounts on long-term gains.
These advantages have caused Roth IRAS to be most popular with young investors. Among Roth IRA owners in 2015,
31% were under age 40 and only 25% were 60 or over, the ICI reports. For traditional IRAS, only 16% of owners were under age 40 and 40% were 60 or over.
Another huge advantage for Roth IRAS is that there are no annual required minimum distributions during the owner’s lifetime. By contrast, owners of traditional IRAS must begin taking RMDS after age 70 ½, depleting and paying tax on their IRA balances.
Young clients may find it hard to envision the value of freedom from RMDS — but its actual value is clearly seen in the actions of IRA owners age 70 and older. Among this group, only 5.7% of Roth owners took distributions during 2015, compared with 80.8% of traditional IRA owners.
This stark difference suggests that at least some owners of traditional IRAS would have preferred to keep their money invested to accumulate greater tax-free returns, rather than take the distributions.
MORE ADVANTAGES OF ROTH IRAS
There are an array of other possible benefits from using a Roth IRA instead of a traditional one. Here are a few:
No age limit: Whereas clients are prohibited from contributing to a traditional IRA once they turn age 70 ½, Roth IRAS have no age limits. That said, Roths are subject to income limits, unlike traditional IRAS.
Roths can complement 401(k)s: Participating in an employer’s qualified retirement plan has no effect on a person’s ability to contribute to a Roth IRA. It also has no effect on being able to contribute to a traditional IRA, but participation in an employer plan may limit the ability to deduct that traditional IRA contribution, depending on income limits.
No penalty on withdrawals: Contributions to a Roth IRA can be withdrawn at any time for any reason, tax-free and penalty free. Withdrawals from a traditional IRA are subject to income tax and generally subject to a 10% early withdrawal penalty if taken before age 59 ½.
Roths raise revenue for Uncle Sam: Another surprising benefit of the Roth IRA results from the fact that it is a tax revenue raiser on a current basis, in contrast to traditional IRAS and 401(k)s, which reduce current tax revenue through the deduction for contributions to them.
This may make the Roth IRA the most politically secure of the tax programs benefiting savers. One recent tax proposal considered by Congress sought to increase revenue by reducing maximum deductible contributions to 401(k)s and pushing savers toward Roths.
Despite all these benefits, the numbers and amounts of conversions into Roth IRAS have remained far behind the comparable figures for rollovers into traditional IRAS.
Paradoxically, it seems investors prefer Roth IRAS over traditional IRAS as an annual savings device, while they remain extremely reluctant to convert distributions from company plans into Roth IRAS.
When pretax funds are held in a traditional IRA, 401(k) or
One huge advantage for Roth IRAS is that there are no annual required minimum distributions.
other qualified employer plan and are converted to a Roth IRA, their value becomes subject to income tax at ordinary rates.
Some clients are so averse to paying taxes that the thought of a current tax hit can stop them from doing Roth IRA conversions — and instead cause them to roll over employer plan funds into a traditional tax-deferred IRA — even when the long-term benefits of a Roth conversion would far outweigh the immediate liability.
HOW ADVISORS PROVIDE VALUE
Advisors can provide real value for clients by examining whether the long-run benefits of a Roth conversion will exceed the current cost and, if so, explain that fact to them. To do this, they should consider the following options:
Plan to convert to a Roth in a low-income year, perhaps after leaving a job or when between jobs or when a client will have business losses or income-reducing deductions. This cuts the tax on the conversion.
Help clients to see the value of tax-free income over their entire lifetime and more. Because Roth IRAS aren’t depleted by RMDS, one can use a Roth IRA to accumulate taxfree investment income for one’s entire life, and then leave the Roth IRA to children or grandchildren, so they get tax-free income over their lives, too. For most beneficiaries, the Roth IRA will also be free of federal estate tax, given the high current exemption.
Avoid stealth taxes and save costs every year going forward by having tax-free, instead of taxable, income. Higher taxable income reduces deductions and increases expenses throughout your return.
As an example, taxes on Social Security benefits and Medicare premiums and the 3.8% tax on investment income may all rise, while income-indexed deductions such as for medical expenses, student loan interest, and real estate losses are reduced. Count the annual tax savings from having less taxable income every year in the future against the one-time tax cost of the Roth conversion.
Not all clients will benefit from a Roth conversion. Clients who will need to consume their retirement savings in the near future, or who can’t pay the tax on a conversion with nonretirement funds, are poor candidates. Clients who are reasonably sure they will be in a lower tax bracket in retirement may also be better off not doing the Roth conversion.
But current tax rates are not guaranteed forever, and Roth IRA conversions can provide tax insurance against possible higher rates, not to mention avoiding RMDS from traditional IRAS if the funds are not converted.
Additionally, Roth conversions can provide tax-risk diversification, so that at least a portion of a client’s retirement funds can be shielded from future taxes.
With $7 trillion now in traditional IRAS and trillions more in employer retirement plans, certainly there are many clients who could gain from doing Roth conversions.
Finding these clients and teaching them may provide great long-term benefits for both them and you.
One key service an advisor can provide is to plan to make a conversion to a Roth in a low-income year.