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.

Financial Planning - - CONTENT - By Ed Slott

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.

TAX IN­SURANCE

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.

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