As a result of recent changes in legislation, clients may face individual income tax rate increases and may also be subject to the Medicare surtax on investment income, limits or phase-outs of certain deductions and personal exemptions; and increases in Medicare premiums.
Roth conversions offer a possible solution to help clients manage taxes in retirement. In considering whether a Roth conversion strategy is right for certain clients, advisors should first consider these building blocks:
- Top marginal tax bracket in early retirement years. The lower the client’s top marginal tax rate early in retirement, the better. The marginal tax bracket may be affected by several factors, including the amount of investment income and withdrawals or gains realized to meet spending needs, the overall portfolio value and mix of assets. For example, if a client has an annual spending need of $250,000, the marginal tax bracket may be as low as 15% or as high as 28%, based on the type of account from which the distribution is drawn.
- Time before RMDs begin. The more time a client has to leverage a lower tax bracket before RMDs begin, and to shift tax-deferred assets to a Roth account, the better the outcome.
- Mix of account types. The mix of account types determines, to a large extent, whether a Roth strategy will work. Note that the mix of account types defines the tax characteristics of a client’s retirement assets. When there is a well-proportioned mix of accounts — including taxable, tax-deferred and even tax-free portfolios — the client has more flexibility to manage taxes during retirement.
But even if a client makes the best possible use of these three building blocks, other factors can make or break the Roth conversion strategy. Among the risks to consider:
- Longevity risk. Because the Roth strategy requires a shift in payment of taxes to the first few years, the longer a client lives, the greater the potential for tax savings and legacy benefits. On the other hand, a premature death may mean the client has pre-paid taxes unnecessarily.
- Portfolio return risk. Portfolio returns — especially if a client enters retirement in a bear or down market and begins tapping taxable assets — may also have a negative effect on this strategy.
- Legacy-transfer risk. To the extent that clients wish to optimize their legacy and transfer assets to heirs in a tax-efficient fashion, a Roth conversion may not be the appropriate strategy for those who may tap the most tax-efficient accounts during retirement and leave the least income-tax-efficient accounts for beneficiaries.
Roths in Reality
To test whether the Roth conversion strategy may be effective for affluent clients, compare tax savings and ending wealth for an RMD approach versus a Roth conversion in two scenarios. In the following example, each couple has a $6 million portfolio.
Couple A retires at age 60, taps taxable assets for income needs, claims Social Security benefits at age 66 and waits until age 70½ to tap their tax-deferred accounts. What are the tax consequences? Even though their spending need was $240,000, because they were drawing from taxable accounts at first and then from Social Security, they were able to stay below the 15% tax bracket until age 70. But at 70½, when they had to start RMDs, their top tax rate was bumped up not one but two brackets to 28%, and they stayed very close to the top of the 28% tax bracket throughout retirement.
What happens if Couple A uses the Roth conversion strategy instead of waiting for RMDs? Early in retirement, they tap their taxable account and, at the same time, take advantage of any unused space before they get to the peak of their top marginal tax bracket by proactively taking the unused space amount from their tax-deferred accounts and converting that amount each year to a Roth. By age 70, when they must begin RMDs, they have managed to reduce their tax-deferred account and reduce RMDs, as well as accumulate wealth in their Roth account.
What are the overall results of these approaches? Using the Roth strategy, Couple A paid $2.16 million in taxes overall vs. $2.51 million for the RMD approach. The Roth approach saved them about 14% in taxes during that time period. From a legacy perspective, the Roth approach achieved 6% greater wealth and even provided for a better mix of retirement accounts.
Another major factor plays a role in determining how effective the Roth conversion strategy will be: the mix of retirement accounts. On the one hand, in a portfolio that has 80% in tax-deferred accounts and 20% in taxable accounts, Couple B has very little flexibility and few opportunities for Roth conversions in the early years. In fact, by age 65, they have depleted both their taxable and Roth accounts.
Thereafter, their income is drawn from their tax-deferred account and Social Security payments.
On the other hand, if Couple B’s retirement portfolio consisted of 80% in a taxable account and only 20% in a tax-deferred account, the cash flow and tax picture would be very different. Because a significant chunk of their portfolio is in a taxable account, they can fully leverage the years between age 60 and 70 to take advantage of lower marginal tax brackets and do the Roth conversions.
To be clear, saving in tax-deferred vehicles is one of the best ways to save for retirement for many reasons: There is power in tax-deferred compounding and growth; tax deferral provides great asset location opportunities by placing income-producing and tactical assets in a tax-deferred account; and clients can maximize retirement savings by making pretax contributions and receiving an employer match. But clients who have fully leveraged tax deferred savings vehicles and have few assets in taxable or tax-free accounts will have little ability to control income taxes in retirement. They should consider shifting some savings to Roth accounts.
Retired clients can find meaningful value by using the Roth conversion strategy for even a few years, particularly as they enter a lower-return world. When it comes to having the right mix of retirement accounts, clients who are still working and have access to a Roth 401(k) may want to consider shifting annual retirement contributions into a Roth 401(k). Clients who are able to save for retirement in a taxable account, traditional 401(k) and Roth 401(k) will be better able to diversify taxes in retirement.
Lena Rizkallah is a retirement strategist at J.P. Morgan Asset Management, specializing in tax policies.
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