Often people leaving the workforce raid their retirement plans to fund current consumption. A departure from the workforce creates an opportunity for people to convert traditional retirement assets to Roth assets at low cost. The low-cost conversion to Roth assets can substantially improve financial outcomes in retirement. Households are only able to make this low-cost conversion if they have a decent ratio of liquid assets to debts.
- A previous post, Financial Tip #5, found that people leaving a firm with a high-cost 401(k) plan should roll over funds from the high-cost 401(K) to a low-cost IRA to increase wealth at retirement. The rollover is often a prerequisite to converting traditional 401(k) assets to a Roth.
- The tax code allows for the conversion of traditional IRAs to Roth IRAs. Distributions from a Roth account in retirement are not taxed and do not count towards the amount of Social Security subject to tax. The person converting previously untaxed funds in an IRA pays income tax on the converted funds in the year of a conversion. The cost of converting traditional assets to Roth assets, the additional tax paid stemming from the conversion, is low when households have marginal tax rates.
- Marginal tax rates are lowest when a worker or a spouse leaves the workforce. This can happen when a person returns to school, decides to care for a family member, becomes unemployed or retires.
- Conversion costs are $0 if AGI including the amount converted is less than the standard deduction ($12,950 for a single filer).
- Conversion costs for single people filing an individual return are 10 percent of taxable income AGI minus the standard deduction for taxable income between $0s and $14,200. Increases in taxable income up to $54,200 increase conversion costs by 12 percent, the marginal tax rate.
- The potential gains from converting traditional retirement assets to Roth assets early in a career perhaps when returning to school are tremendous.
- A person leaving the workforce for school for a couple of years at around age 28 might convert $20,000 from a traditional IRA to a Roth at a cost of around $2,000.
- The balance of the Roth account from this conversion after 30 years assuming a 6.0 percent return is $114,870.
- The direct tax savings from the conversion assuming a tax rate of 10 percent would be $11,487. An indirect tax savings from the omission of tax on Social Security, assuming around $50,000 in Social Security payments spread over a couple of years, would be around another $5,000. The conversion can be thought of as an investment of $2,000 leading to a return of around $16,000 in around 30 years. The rate of return for an investment of $2,000 and a return of $16,000 in around 30 years is around 7.2%.
- A person in a low tax bracket because she is young and single and returning to school and only working for the part of the year could be in a much higher tax bracket in retirement, especially if married and both spouses worked and claimed Social Security. In many cases, the returns from converting a traditional IRA to a Roth will be much higher than the one reported by the simple example in the above bullet. A person living 100 percent on Roth distributions and Social Security could easily pay $0 in annual tax after accounting for the standard deduction.
- A person returning to school full time with no reported earnings could convert an amount equal to the standard deduction to a Roth and pay no additional tax. It would be irrational for a person with a 0 percent marginal tax rate to fail to make a conversion.
- Workers leaving the workforce are often more concerned about meeting immediate needs than for planning for retirement. However, conversion costs are small during a year a person leaves the workforce.
- Workers leaving the workforce with debt or with 401(k) loans often distribute funds from their 401(k) plan, pay a penalty and tax, and are unable to rollover or convert funds to a Roth.
- The five-year rule imposes tax and penalty on funds disbursed from a Roth IRA funded through a conversion from a traditional IRA within five years from January 1 of the year of the conversion. A separate five-year waiting period is applied to each conversion. The five-year rule applies for conversions after age 59 ½ even though all funds in Roth accounts funded by contributions can be withdrawn without penalty and tax at that age. The purpose of the five-year rule for conversions and its implementation even after age 59 ½ is to prevent immediate access to funds in a traditional retirement account. The five-year rule for conversions appears to apply to disbursements from both contributions and earnings for both pre-tax and after-tax IRAs.
Concluding Remarks: The cost of converting a traditional IRA to a Roth IRA, the additional tax paid on the amount of the conversion, is generally low in years where a person leaves the workforce. The potential tax savings in retirement is considerable.
Several additional posts on IRA conversions are planned. One post considers issues related to conversions of non-deductible IRAs in a procedure called a backdoor IRA. A second post considers the advantages of converting pre-tax IRAs during retirement.