Now Is The Ideal Time For Roth Conversions

Let me suggest two excellent money moves. You’ll enjoy tax deferral — inside buildup in which the asset-income you earn on your balances accumulate tax-free. You also get to time your IRA withdrawals to years when your marginal tax bracket is low.

Like many, if not most, Americans, you probably are holding much of your traditional IRA in cash. With the stock market’s price-earnings ratio registering over twice its historic value, that path to riches seems massively overrated.

This is particularly the case given the uncertainty about 1) annual inflation staying at 7 percent or going higher, 2) the Fed’s raising interest rates, 3) the precise course and curse of Omicron, 4) the potential for a new, deadlier variant to emerge in the unvaccinated world (which includes much of our country), 5) the potential end of American democracy as flag-drapped traitors seek to ensure only white skins get to vote, 6) Russia invading Ukraine, which all the attendant potential for WWIII, and 7) China invading Taiwan leading the world’s two largest economies ending commercial ties, 8) Iran deploying a nuclear weapon, and 9) North Korea developing nuclear-armed subs to patrol our shores.

The risk premium on stocks has rarely been higher. Yes, there are deluded investors who think that stocks are safe in the long run. If this were the case, no one would be buying bonds guaranteeing negative real returns. I refer here to the negative real returns on TIPS — Treasury Inflation-Protected Securities.

As for investing in short-, medium-, or long-term bonds, their expected real yields are extremely low given we are running a 7 percent annual inflation. Yes, Jerome Powell and the markets tell us that the recent 40-year high inflation rate is a temporary blip. But I, for one, don’t want to watch my cash holdings or nominal bonds spend another year losing 7 percent of their real value.

The other investment options are real estate, whose values are high, Bitcoin — a security grounded in insecurity, gold, which has never been a perfect inflation hedge, commercial real estate, which is in tough competition with our bedrooms, and inflation-indexed bonds, as well as I-bonds, that protect against inflation. But TIPS offer a reliable negative real return and I-bonds later can only be purchased in limited quantities. Investing in the securities of foreign countries with stable governments, rule of law, and adults running their central banks and treasuries is a reasonable approach.

But the performance of the assets in those countries depends heavily on how U.S. asset markets perform.

Rather than just wring my hands, let me suggest two excellent money moves. The first is to pay off high-interest debts starting with credit card balances, followed by student loans, followed by mortgages. Discharging these IOUs, even with money you withdraw from your taxable IRA, can pay off in spades. (See my new book, Money Magic, for a discussion.) The second move is to take funds on which you owe taxes and are earning a negative real return and pay off the taxes owed. A Roth conversion does this.

Sounds crazy, no? The advantage of retaining assets in a traditional IRA, whose balances are taxable when withdrawn, are twofold. You enjoy tax deferral — inside buildup in which the asset-income you earn on your balances accumulate tax-free. You also get to time your IRA withdrawals to years when your marginal tax bracket is low.

But these days, tax deferral is negative since real interest rates are negative. Moreover, since nominal, not real interest income and nominal, not real capital gains are subject to taxation, the advantage of deferral has always been less than advertised. Given this, it makes very good sense to pay to Caesar (Uncle Sam) what is Caesar’s (what we owe Uncle Sam) and do so immediately.

Why take, say, $10,000 on which we owe $3,000 in taxes and invest it at a negative return for say ten years. Leaving aside taxes on asset income and inflation, today I have $10K to pay the $3K. Down the road I’ll have less than $10K to pay the $3K. I’m better off paying the $3K now. Doing so means I’ll lose money only on $7K, not on $10K.

Adding in inflation and taxes on nominal asset returns strengthens the case. If we don’t Roth convert, we’ll have less real assets, but a higher real tax liability since, again, nominal, not real income is taxed. Were the tax liability fixed in nominal returns, it could be paid off in watered-down dollars. But that’s not the case. Inflation raises nominal returns and, again, it’s nominal returns that are subject to taxation.

Better to give Uncle Sam the dollar bills we now owe him and let him watch their purchasing power shrink on a daily basis. This argument for doing substantial Roth conversions is reinforced by the near surety that taxes will be raised in the near term. The stark reality is that the U.S. is dead broke. It’s arguably the most fiscally imperiled of all the world’s developed countries.

And not because of the official debt that our “leaders” disclose, but because of the seven-fold higher debt they conceal in the form of unfunded, off-the-books obligations to pay Social Security, Medicare, Medicaid, defense spending, you name it.

To illustrate the potential gain from doing a Roth conversion, I set up, in my company’s software, MaxiFi.com, a case of a hypothetical retired 62-year old single living in Arkansas. Joe, for lack of a better name, has $1.25 million in his checking account. He has $3 million in his traditional IRA. Also, he receives $75,000 a year adjusted for inflation from a company he owns.

Suppose Joe Roth-converts $200,000 for 10 years, the gain in lifetime spending, measured in today’s dollars, is a massive $157,000. If taxes are increased by 30 percent starting in 2030, the gain from the Roth conversions totals $271,000. That translates into a 5 percent hike in Joe’s living standard year-in and year-out through the end of his days. That’s good to great pickins for a financial move entailing zero risks!