Combining Roth IRA Conversions and Long Term Investments

Roth IRA Conversions and Long Term Investment Time Horizons in Advanced Financial Planning: Why Both Are Growing in Importance and Why the Two Can Be a Powerful Combination

The SECURE Act of 2019 changed financial planning for the middle class, but especially for high-net-worth and ultra-high-net-worth families. In particular, the potential combination of Roth IRA conversions and maintaining long-term investment time horizons has assumed strategic significance because together, they enable financial planning to effectively integrate key priorities of retirement planning, tax planning, and estate planning.

Individual Retirement Accounts (IRAs) have long been key elements of advanced financial planning – for retirement planning, retirement income, and estate planning.

People who have a traditional IRA have for several decades enjoyed the option of converting part or all of it to a Roth IRA. Anytime a conversion is made, ordinary income taxes are due as if a distribution from the IRA had occurred. On the other hand, once converted to a Roth, the Roth funds are no longer subject to either income taxes or capital gains taxes. And the Roth IRA can become a resource for later stages of retirement because it eliminates the required distributions.    

This becomes especially advantageous if you consider the complementary, reinforcing benefits of continuing to use a 10-year investment horizon well into old age (see below). The Roth can have time to accumulate, and funds can be allowed to grow or be withdrawn at the discretion of the account owner. When there are withdrawals, they’re tax-free. So are any withdrawals from Roth IRAs which are inherited.

Whether or not to convert a traditional IRA to a Roth IRA always depends on a variety of financial planning factors, including marginal tax rates at present and in the future, as well as identifying potential investment opportunities which could escape all future capital gains taxes. And your cash flow. And your management of short-term risk.

All these factors, as well as many others, help determine whether a Roth conversion is a relatively good or relatively bad choice.

The SECURE Act changed a lot of retirement rules and a lot of financial planning incentives. One of the most significant changes is that almost all non-spouse beneficiaries must now withdraw all funds from the IRA within ten years of the death of the account owner.

That new rule eliminates the stretch IRA, a technique that has been used to extend the IRA through the life of the beneficiary – which could stretch the withdrawals for 40 or 50 years. Congress sees the SECURE Act as a means to squeeze revenue out of higher-earning taxpayers. Many beneficiaries will inherit the IRA in middle age, at the peak of their earnings. Congress clearly hoped that the 10-year requirement would push lots of people into higher tax brackets.

That’s a big change, potentially increasing the appeal of Roth IRA conversions as a part of your financial planning.

The stretch IRA used to be a strong financial planning argument against doing Roth IRA conversions. Paying taxes upfront is rarely the best choice. And Roth IRA conversions require taxes to be paid immediately. The ability of a beneficiary to dribble out distributions over a lifetime was a pretty strong financial planning rationale for standing pat, and the estate planning factors also tended to support keeping the traditional IRA in place.

All these financial planning calculations have changed. The traditional IRA, especially when it’s a big IRA, has become an unattractive vehicle for wealth transfer and estate planning. On the margin, Roth conversions have become more attractive. A beneficiary of a Roth is subject to the same 10-year rule, but there are no taxes. So even compared to the traditional stretch IRA, the inherited funds can be invested completely tax-free throughout those ten years – and then withdrawn tax-free at the very end of the 10-year period. From the estate planning angle, inheriting a Roth IRA is inheriting a great nest egg.

Another thing to keep in mind is the political environment. There are strong forces pressing for tax rate increases. That pressure shows no sign of disappearing anytime soon. One can’t assume so easily that tax rates during retirement will be a lot lower than those during working years. This is especially true when the financial planning is for families who have accumulated significant wealth.

So paying taxes now and permanently putting the funds in the converted Roth beyond the reach of future income or capital gains taxes is more attractive now that the SECURE Act is the law.

Finally, the Roth conversion may be an excellent financial planning tool to blend with a variety of charitable tax planning and estate planning strategies. Many of these charitable financial planning techniques produce tax deductions, a benefit that can mitigate the tax liability of Roth conversion.

So as you consider all your retirement planning, retirement income, and estate planning factors, keep in mind that the SECURE Act may have tilted your decision-making toward doing Roth IRA conversions.

Long Term Investment Time Horizons: A Force Multiplier for Roth IRA Conversions?

The 10-year rule for inherited Roth IRA conversions also should help you focus on the huge potential benefits of compounding when holding good investments for longer investment time horizons. Roth IRA conversions equal tax-free appreciation for the rest of the owner’s lifetime plus ten more years of tax-free appreciation for the beneficiary.

This raises a related question: When in life is a long-term investment time horizon no longer necessary in financial planning? When financial planning is given the opportunity to harness compounding, as in the case of Roth IRA conversions, that answer may be never.

The likelihood of living to 100 and beyond is a growing trend. As a matter of financial planning, the number of years as an active individual, family, or business owner are all increasing. Financial planning and wealth management need to reflect this. A client deserves financial planning which incorporates expectations about lengthening lifespans for multiple generations.

Cards on the table: We are strong advocates of time allocation in investing – being prepared to hold for seven or, better, ten years investments whose purpose is capital appreciation.

A fairly common approach in financial planning and retirement planning is to suggest that people should become supposedly more conservative as they age by adjusting asset allocations away from stocks and toward more fixed income.

But the years of adult life in retirement and without salaried income are increasing. Ratcheting down investment time horizons damages potential capital appreciation. When viewed in combination with the potential benefits of Roth IRA conversions, permanently maintaining longer investment time horizons as a pillar of your financial planning, retirement planning, and estate planning can make a lot of sense.

So-called conservative strategies too focused on fixed income create a risk of running out of money. Too “conservative” might actually become too risky. We’re never too old for maintaining a portion of our assets in investments we need to be willing to wait at least ten years for. Higher-returning investments deserve to be a component of your investment strategy throughout your life. Along with Roth IRA conversions, longer investment time horizons deserve serious consideration when doing strategic, long-term financial planning.

Interested in a free assessment? Please click here.