Roth IRAs become 20 years old in January of 2018 and now hold more than $660 billion in retirement wealth, reports the Investment Company Institute (the source of the data in this article).
Yet while Roth IRAs have become very popular among individuals who make annual contributions to IRAs, they are near totally avoided by persons who roll over big-dollar distributions from company retirement plans into their IRAs, with these funds going overwhelmingly into Traditional IRAs.
This suggests that some people are undervaluing the benefits of making a rollover into a Roth IRA. If you are either an individual with funds to roll over or a financial advisor with such individuals as clients, it may pay to re-examine the benefits of choosing a Roth IRA to be the destination of a big-dollar rollover.
Contributions to Roth IRAs exceeded those to Traditional IRAs by $21.9 billion to $17.5 billion in 2014, even though only about one-third of IRA owners have a Roth. Yet Traditional IRAs now hold near $7 trillion in assets, dwarfing the total in Roths. The main reason is that rollovers of large balances from employer plans flow overwhelmingly into Traditional IRAs. Rollovers totaled $423.9 billion into Traditional IRAs versus a mere $5.7 billion into Roth IRAs in 2014 – Traditional IRAs received 98% of rollovers.
This seems paradoxical. If investors prefer Roths to hold their annual contributions, why are they so extremely adverse to having Roth IRAs receive and hold their accumulated employer plan savings?
The benefits of Roth IRAs over Traditional IRAs appear most valuable to persons with large IRA balances that exceed the amount they will have to withdraw to live on. Roth IRAs allow the entirety of such large balances to remain invested for tax-free returns over one’s entire lifetime – and then, through stretched distributions, also earn more over the lifetimes of one’s beneficiaries. Traditional IRAs require balances to be distributed and taxed over one’s own life expectancy through annual required minimum distributions (RMDs) starting at age 70 1/2, even if one doesn’t need the money. Yet owners of such large plan balances overwhelmingly roll them over into Traditional IRAs.
The apparent reason: When pre-tax funds in a company plan such as a 401(k) are rolled over into a Roth IRA, they are subject to income tax as they are converted to post-tax funds. Most people just don’t want to pay that tax!
Reconsidering the Tax Bill
But not even considering paying the tax on a Roth conversion may be a big mistake because: (1) the tax may be greatly reduced with planning; (2) paying the one-time current tax can reap decades of tax benefits; (3) reducing taxable income can indirectly produce other savings throughout a tax return.
The tax on moving funds into a Roth IRA may be sharply reduced by making a series of partial rollovers. The funds don’t have to go all at once. Partial rollovers can prevent the taxable income on conversions from piling up into higher tax brackets. Converting just 5% or 10% of plan funds every year can convert them all over time with minimum income tax cost.
One can also vary the size of partial conversions with one’s current tax situation, converting more in low-income years. If one can predict that a coming year will be low-income – perhaps between jobs or after retiring – one can time deductions to take then (such as for charitable donations and business expenses) to shelter more of a conversion from tax.
Add into your calculation unexpected savings from a Roth conversion. Reducing taxable income may reduce income tax on Social Security benefits, and also the cost of Medicare premiums for Part B and Part D. It can also reduce ‘stealth taxes’ that result when income rises, such as the 3.8% tax on net investment income, and the cut-back of many deductions that occurs as income rises. Under current law these include casualty loss and medical expense deductions and many more. (Tax Reform may change the details of these – but Congress has applied income related limits to deductions since the income tax was created, so consider the principle to continue.)
Remember, after conversion all these benefits will occur every year into the future, and over your beneficiaries’ lives too, should you leave funds to them.
Not everyone will benefit from a conversion to a Roth IRA. A person who will need to consume retirement funds in the near future, or who lacks money in a taxable account to pay the tax on the conversion, may not be a suitable candidate.
But advantageously moving even a small portion of the trillions of dollars in employer plans into Roth IRAs instead of mistakenly into Traditional IRAs may provide great benefits to the IRA owners, and their financial advisors as well.