Target – Getty
I wrote an earlier version of this column rather quickly, without writing down the math. The point made before — that this is a good time to do Roth conversions — stands, but I want to be more precise. First, Roth conversions make sense when your tax bracket is temporarily low. Given our country’s long-term fiscal insolvency, tax rates are likely to be raised. Meanwhile, the real long-term pre-tax return we can earn from saving is essentially zero, but we have to pay taxes on nominal, not real income. Finally, the investment climate is highly uncertain suggesting the value of paying off sure liabilities.
Investing these days, particularly in the stock market, is scary. The stock market’s PE ratio is historically very high. There is also considerable uncertainty about 1) annual inflation staying at 7 percent or even 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 our largely unvaccinated world, 5) the likelihood of domestic political upheaval, 6) and geopolitical uncertainty involving Russia, China, Iran, and North Korea.
The risk premium on stocks has rarely been higher. Yes, there are 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 I write, 30-year TIPS are yielding negative 11 basis points. Thirty-year nominal Treasuries are yielding 2.14 percent. The implied long-term inflation rate is 2.25 percent. That’s a far cry from the 7 percent inflation rate we experienced last year.
Let’s do a thought experiment. Let’s assume you are investing your IRA in stock, but we risk adjust it by considering your investing it in long-term TIPS. Suppose the real long-term rate is zero (not 11 basis points to keep things simple) and that the inflation rate averages 5 percent, not 2.25 percent through time. Also suppose you have a $1.5 million traditional IRA and face a $500K tax liability were you to Roth convert your IRA today. If you invest, as I’m assuming, your IRA in TIPS, the real value of your holdings will stay even with inflation (again the nominal interest rate is just the inflation. rate). But when you withdraw your IRA down the road, say in 15 years, you’ll pay taxes on its huge nominal accrued interest, even though its real accrued income is zero. Indeed, your real tax bill will double due to inflation. This provides a significant reason to convert now. Layer on the potential for tax rates to rise substantially and the gains from conversion become major.
Everyone’s situation differs. But, of late, I’ve been running conversion scenarios in my company’s MaxiFi Planner software assuming high inflation and high nominal interest rates and a 25 percent permanent federal tax hike starting in 2020. The gains from converting run in the tens of thousands of dollars. My bottom line. If you are in the market and worried sick, maybe it’s time to trade your sleepless nights for paying off a tax liability that you’re going to face one way or the others, but doesn’t require paying additional taxes based on unreal income.