January 1 marked the 20th birthday of the Roth IRA retirement account. In the past two decades, Roths have grown to hold more than $660 billion in assets, according to the Investment Company Institute. But as popular as they have become, they are still greatly underused.
Investments held in Roth IRAs totaled only about 8% of the $7.9 trillion that was held in IRAs overall at the end of 2016, according to ICI.
This huge disparity exists in large part because big-dollar rollovers from employer-sponsored qualified retirement plans (which can rise into the millions of dollars) are made overwhelmingly into traditional IRAs, not Roths. Roth IRAs, instead, remain funded predominantly by smaller contributions that currently cannot exceed $5,500 annually for most investors, and $6,500 for those who are age 50 and older.
CLIENTS COULD BENEFIT, BUT STILL DON’T DO IT
In 2015, 85% of newly opened traditional IRAs were funded solely by rollovers, while the figure was only 15% for new Roth IRAs, says the ICI. During the nine years from 2007 through 2015, only 6.9% of Roth investors did a Roth conversion.
These facts suggest that many clients who could benefit from doing a Roth conversion are failing to do so. Why? Maybe they are deterred by the current tax liability that results when you convert pre-tax 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 current tax bill.
Planners who can advise clients on conversions can provide great benefits to both those clients and their own practices.
ADVANTAGES OF THE ‘OPPOSITE’ IRA
The Roth IRA was created as a mirror image in many ways to traditional IRAs. To begin, contributions to traditional IRAs were generally deductible and distributions from them were taxable at ordinary rates, whereas with Roths, it’s the reverse: Contributions became nondeductible and distributions later 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. A person tends to be in a lower tax bracket early on in their career, and a higher one later, when they’re earning a higher level of income. In this scenario, the Roth IRA can produce large tax savings.
Roth IRAs are also opposite from traditional IRAs when investing for long-term capital gains. When such gains are distributed from traditional IRAs, they are taxed at top ordinary tax rates, not the normal lower long-term capital gain rate, making traditional IRAs inferior to taxable accounts. But Roth IRAs can 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, 31% were under age 40 and only 25% were age 60 or over in 2015, reports ICI. For traditional IRAs, only 16% of owners were under age 40 and 40% were age 60 or over.
Another major advantage for Roth IRAs is that they need not pay out annual required minimum distributions during the Roth IRA owner’s lifetime. In contrast, owners of traditional IRAs must begin taking RMDs after age 70 1/2, depleting and paying tax on their IRA balances over their life expectancies.
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 to 80.8% of traditional IRA owners. This stark difference suggests that at least some of the owners of traditional IRAs would have preferred instead to keep their money invested for more tax-free returns, rather than take the distributions.
MORE ADVANTAGES OF ROTH IRAS
- No age limit: Whereas clients are prohibited from contributing to a traditional IRA once they turn age 70 1/2, Roth IRAs have no age limits. That said, Roths are subject to income limits unlike traditional IRAs. High-income clients can use Roth conversions, which are not subject to any income limits.
- Roths can compliment 401(k)s: Participating in an employer's qualified retirement plan has no effect on a client’s ability to contribute to a Roth IRA. It also has no effect on being able to contribute to traditional IRA[AK1] , but participation in an employer plan may limit the ability to deduct that traditional IRA contribution, depending on income limits.
- No penalty on withdrawl conributions: Contributions to a Roth IRA can be withdrawn at any time for any reason, tax-free and penalty free. Contributions to a traditional IRA are subject to income tax and generally subject to a 10% early withdrawal penalty if taken before age 59 1/2.
- 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 tax programs benefitting savers. An illustration of this is the recent tax reform proposal considered by Congress to increase revenue by reducing maximum deductible contributions to 401(k)s and push savers towards Roth 401(k)s.
But despite all these benefits, the numbers and amounts of conversions into Roth IRAs have remained far behind the 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.
OVERCOMING RESISTANCE TO A ROTH CONVERSION
When pre-tax funds are held in a traditional IRA, 401(k) or other qualified employer plan and are converted to a Roth IRA, their value becomes subject to income tax at ordinary rates.
Some persons are so adverse to paying taxes that the thought of this current tax hit can stop them from doing Roth IRA conversions — and instead cause them to roll over employer plan funds into a traditional IRA, tax-deferred — even when the long-term benefits of a Roth conversion would far outweigh the current cost.
WHERE ADVISORS CAN PROVIDE REAL VALUE
Advisors can provide real value when they assist clients by examining whether or not the long-run benefits of a Roth conversion will exceed the current cost, and if so, explain that fact to them. Then consider the following options:
- Plan ahead to make the conversion in a low-income year, perhaps after leaving a job or when between jobs... or when the client will have business losses or other income-reducing deductions. This reduces 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 tax-free investment income for the entire rest of one's 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 be free of federal estate tax too, given the high current federal estate 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. Examples: Tax on Social Security benefits, 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 into 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 non-retirement 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 that leaves them open to the uncertainty of how future higher tax rates might affect them in retirement.
Roth IRA conversions can provide tax insurance to protect against this contingency, not to mention avoiding RMDs from traditional IRAs if the funds are not converted.
Additionally, explain how 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 company plans, certainly there are many clients who could gain from doing Roth conversions. Finding them and teaching them about that fact may provide great long-term benefits to both them and you.