The long-delayed passage of the SECURE Act by the Senate last week makes for significant tax law changes with perhaps the biggest impact being the death of most “stretch IRAs”. The CBO estimates that added tax revenue over the next 10 years (2020 – 2029) from this provision will be $15.7 billion. Nothing else in the plan even comes close to this kind of economic impact. Although the CBO only scores the revenue impact for the next 10 years, the financial cost for beneficiaries in the 2nd and 3rd decades after the law changes will be a dramatically larger number than the $15.7 billion in the first decade. If you’re looking for the one tax law change with the most financial impact (revenue for the government, cost for taxpayers), look no further.
Up until now, a Traditional IRA, Roth IRA, or other qualified retirement account could be left to living beneficiaries who could then “stretch” the distributions over their respective lifetimes. Such a technique took advantage of extended tax deferral for inherited Traditional IRAs and of extended tax-free growth for inherited Roth IRAs.
A 30-year old who inherited an IRA, for example, could systematically distribute the IRA over the next 54 years (based on a statutory table provided by the IRS) rather than distribute everything soon after the inheritance. With wise distribution planning by a young beneficiary (i.e. child or grandchild), this exploitation of the tax law and extended compounding effects of tax deferred or tax-free growth could literally result in millions of dollars in extra tax savings on a $500,000 IRA account. All the while, the stretch IRA created a lifetime annuity.
While existing inherited IRAs (or any IRAs that are inherited before Jan 1, 2020) can still take advantage of the stretch benefits, the SECURE Act effectively ends (or dramatically curtails) the stretch IRA strategy in the future by requiring that all retirement accounts for beneficiaries inherited in 2020 or thereafter be distributed within 10 years of death (notably, there are exceptions such as surviving spouses and disabled beneficiaries).
Following passage of the Act, several planning articles suggested that the end of the stretch IRA now makes Roth conversions more favorable. An InvestmentNews article last week recommended that “the time is ripe to convert traditional, pretax retirement accounts to Roth-style accounts” and predicts that “Investment advisers are going to put a premium on Roth conversions.” Another article suggests that “it is going to be critical to execute Roth conversions on the highest scale possible.”
But here’s the glaring issue – Roth conversions become less favorable, not more favorable, under the new law. Recall how Roth conversions work: when you convert tax-deferred “Traditional” assets to a tax-free Roth account, the conversion amount is treated as ordinary income and you face an immediate tax liability on that amount of income. You then enjoy the benefits of tax-free growth on the converted amount such that when you (or your beneficiaries) withdraw the funds from the Roth, there is no additional tax.
As nice as “tax-free growth” sounds and is, Roth conversions are not a free lunch and should not get a free pass. The mathematical evaluation of Roth conversions hinges on a comparison of the initial up-front cost of the conversion (the immediate tax) to the expected future benefit (of tax avoidance in the future). While it is a not-so simple net present value calculation that depends on a number of variables, the result of this evaluation is largely determined by tax rates – the tax rate at the time of conversion versus the anticipated tax rate when the assets are expected to be withdrawn. If the current tax rate is lower than the expected future tax rate when the assets are going to be distributed, then the conversion math makes sense. If the current tax rate is higher than the expected future tax rate, then a conversion should be avoided.
The fundamentals of that evaluation do not change. A Roth conversion that made economic sense before the SECURE Act, makes sense after it. And vice versa. But the Act’s new 10-year mandatory distribution period for IRA beneficiaries reduces the time period over which the benefit of tax-free growth can accrue. And that’s extremely important – especially when the beneficiary may be a child or grandchild with a time horizon of 40 years or more. It’s not that there stops being a benefit to Roth conversions in the right situations – it is most Roth conversions just become less beneficial under the new law.
Consider the case of a 68-year old IRA owner who is considering a $10,000 Roth conversion with the eventual goal of leaving the Roth IRA to his 12-year old granddaughter, Amy. By his projections, he will be able to convert at a 25% tax rate (tax of $2,500) and eventually leave the IRA to Amy who is projected to face a 35% tax rate in the future. The grandfather converts $10,000 from IRA to Roth IRA, pays the $2,500 tax and the Roth account grows for another 18 years until his death when Amy is now 30-years old.
Under the current (until Jan 1, 2020) distribution rules, Amy can let the tax-free compounding of the Roth IRA accrue for another 54 years while taking required annual distributions over that time period. Under the new distribution rules, Amy inherits the Roth account and is then forced to distribute it entirely within 10 years – dramatically reducing the tax-free compounding period from 54 years to 10 years.
Notably, the Roth conversion is beneficial in both scenarios – under the current law and the new law. It is – again – just that the conversion is less beneficial under the new 10-year distribution rule. Under the current law, Amy winds up with 44% more dollars from her grandfather having done the conversion than not converted. Under the new law, that advantage drops to 23%[i].
What’s the takeaway? To be clear, it is not that Roth conversions should be avoided under the new tax law. When the expected future tax rate – for you or your beneficiaries – is higher than your current tax rate, Roth conversions serve a valuable purpose. But, there seems to be this new promotion of Roth conversions in light of the accelerated beneficiary distribution rule. Any such promotion is either misinterpreting or misunderstanding the results. The takeaway is that Roth conversions are generally less beneficial under the new law with the shorter time period to accrue the tax-free growth benefit.
Kudos to advisors and consumers who were already evaluating and executing annual Roth conversions in low tax years. Advisors and consumers who are just beginning to evaluate or promote Roth conversions in light of the SECURE Act have simply been missing out on an outstanding opportunity – an opportunity that still continues in the future – albeit with a diminished benefit. The idea that investment advisors expect a pickup in conversion of traditional IRAs to Roth IRAs as a result of the SECURE Act, if true, is an embarrassing statement about the investment advisor community. Said differently – if you ask your advisor whether you should begin to consider annual Roth conversions in light of the tax law change and he or she says yes, the real question that needs to be addressed is why you have not been exploiting this opportunity in the past.
[i] There are a number of assumptions here. In this evaluation, it is assumed that the $2,500 upfront tax liability is paid with non-IRA assets such that in the “no-conversion” control scenarios, a side account is tracked with the $2,500 that was saved from avoiding the tax liability. We assumed a 7.0% pre-tax rate of return for the invested assets and a 6.5% after-tax rate of return. Increasing the difference between the pre-tax return and after-tax return increases the benefit of conversion in both scenarios but more so under the old (pre-2020) distribution rules. It’s assumed that minimum required distributions are withdrawn minus any associated tax liability and invested in a taxable account. In the case of the inherited IRA accounts under the new SECURE Act rules, we assume that Amy distributes the IRA accounts at the end of the 10th year. While the benefit percentages will change when any of these assumptions change, the important point is the concept that the Roth conversion becomes less beneficial in the future.