Roth Conversions; No Guarantees – Part 3 of 4

 

Uncertain outcomes have always existed and always will. We live in a world defined by uncertainty and decision risk, and the goal of sound planning is not to eliminate it, but to take deliberate, strategic steps that reduce unfavorable risks and increase the probability of achieving the outcomes we want.

Given that uncertainty touches every aspect of our lives, the decision to convert assets from pre-tax to Roth accounts is no different. But what about the certain break-even analysis? Any analysis is only as good as it’s known inputs. A break-even calculation based on the cumulative accumulation of Roth assets is simple and straightforward. However, in the real world, this seemingly simple analysis comes with important caveats and exogenous factors that make it far less clear cut than it appears.

 

a lot can change over the next 20 – 30 years...

1. Longevity Risk –

This factor goes hand in hand with the previously discussed break-even analysis. If an inflation adjusted plan shows that prior conversions produce a net economic benefit only after a certain age, but the individuals in the plan pass away before reaching that point, then the intended tax benefit is never realized during their lifetime. If family longevity patterns suggest it is unlikely the retiree will live past the break-even age, the conversion may not create meaningful economic value for them and instead primarily benefit beneficiaries who receive the assets as a tax-free inheritance.

2. Lower Future Tax Rates –

Though not probable, anything can happen. If taxes rates are unexpectedly lower in the future vs. assumptions built into the model, then conversion viability losses ground

3. How Taxes are Paid –

Because taxes must be paid at the time of conversion, the source of those funds directly affects the long-term viability of the strategy. Taxes paid represent an opportunity cost since capital used to satisfy the liability no longer compounds. Using the converted IRA assets themselves to pay the tax is the least efficient option because it reduces the initial Roth principal and alters the long-term growth trajectory, likely eliminating most if not all the economic benefit. The most efficient funding source is the asset with the lowest expected growth rate and the lowest tax impact upon liquidation, ideally cash or cash equivalents. Ultimately, the success of a Roth conversion depends not only on tax rates but on which asset absorbs the cost of prepaying the taxes.

4. Underperformance of the Converted Assets –

Performance of the converted assets is a critical foundation of any Roth conversion strategy. If markets underperform over the relevant time horizon, the long-term outcome of the conversion can be neutral or even negative. This risk is magnified if the converted assets themselves are used to pay the tax, because the starting value in the Roth is reduced from day one. Extended periods of weak returns, such as the first decade of this century often referred to as the lost decade for U.S. equities, can materially undermine the economic case for prepaying taxes and may ultimately result in a net negative outcome.

side note: historically and where applicable, market downturns can present an ideal opportunity to convert pre-tax assets to a Roth.

5. Political risks and implications –

The political risk of a Roth conversion is that it relies on today’s tax rules lasting for decades. Lawmakers can change tax rates, add surtaxes, adjust Medicare or Social Security formulas, or limit inheritance benefits, which could reduce or indirectly erode the value of tax-free Roth withdrawals. Because conversions are long-term decisions, any legislative change can shift or eliminate the expected break-even advantage.

These are not the only exogenous unknowns affecting the long-term viability of Roth conversions. For example, unexpected liquidity needs and corresponding distributions earlier than planned may negate the anticipated benefit. However, with the guidance of an independent CFP® professional using both qualitative and quantitative analysis, a central tendency or directionally prudent decision can be evaluated and implemented.

Summary:

Nothing is guaranteed, plain and simple. This absolutely is the case given the number of unknown variables that affect the Roth conversion decision. But the reality is, that by assessing Roth conversions from an unemotional, and analytical perspective, and making the best most optimized decision given all known and available information while taking into consideration external unknowns, can help you potentially either alleviate future tax liabilities, or mitigate the potentially consequential impact of doing so when it didn’t make sense to in the first place. This is a probabilities business, make sure that you are working with a financial planning expert who can help you assess both the knowns, and unknowns associated with this and other financial planning strategies to increase your probabilities of success.

In part 4 of 4, I will discuss Vanguard Group’s BETR analysis, in hopes of sharing a common sense, marginal, and applicable approach to Roth conversion analysis.