Though stocks have bounced off their recent bear-market lows, earnings season and economic uncertainty add up to more volatility ahead. On the bright side, market losses open the door for investors to take advantage of a tax-savvy but potentially tricky strategy: the Roth IRA conversion.
In doing so, you’ll owe income tax today on the value of what you convert from your 401(k) or traditional individual retirement account, but then you—or your beneficiaries—don’t need to worry about paying taxes on that savings going forward. Although new Roth contributions are subject to income limits, there are no such restrictions on Roth conversions. Roth IRAs are funded with after-tax dollars, leaving the investments to grow tax-free.
Advisors say that Roth conversions are an all-weather strategy, but today’s market and recent legislation make the move all the more compelling. Most asset classes have taken a beating, so all things being equal, you’ll pay less in taxes on a conversion today than you would have a few months ago.
“If your IRA was worth $100,000 and has dropped to $80,000, that might be the difference of paying $24,000 in taxes for the conversion earlier this year versus $19,000 today, assuming a 24% tax bracket,” says Todd Soltow, co-founder of Frontier Wealth Management in Spring, Texas.
Roths also make sense for estate planning thanks to the retirement system overhaul passed late last year. Before this year, IRA beneficiaries could stretch distributions—and, in turn, the tax—over their lifetimes. Now, under the Secure Act, non-spouse beneficiaries need to pay taxes on inherited IRAs within 10 years. “What’s neat about a Roth is you can leave money to your beneficiaries without the tax consequences,” says Soltow.
There are two ways to shift retirement assets into a Roth: You can make an in-kind transfer in which you move securities or funds over without liquidating them. The benefit is that money is never out of the market.
Another option is to cash out of one account and start with a clean slate in the Roth. This can be done via your financial institution directly or through an indirect rollover where you receive the distribution and reinvest, though you’ll need to complete the transfer within 60 days. This strategy might make sense if you wanted to change your allocation or underlying securities anyway. Don’t think of it as “locking in your losses,” says Soltow. “Think of it as taking a different strategy toward recovery.”
Other reasons to roll into a roth
You don’t need portfolio-wide losses for a Roth conversion to pay off. “We’ll look at the positions that have been hit the most and move those over to a Roth,” says Anne Marie Stonich, managing director of financial planning at Paracle Advisors in Seattle.
This is a strategy she and her team employ in any market, particularly when clients find themselves in a lower tax bracket. For example, new retirees might have a window of low taxes before they claim Social Security benefits. Business owners and investors with pass-through losses can also use unusual tax years to their advantage.
Many advisors advocate Roth conversions as a hedge against future tax increases. “If the government decides, with the stroke of a pen, to raise taxes, Uncle Sam has a bigger interest in your retirement savings,” says Soltow. While nobody can predict future taxes, unprecedented federal spending due to the Covid-19 pandemic is adding to an already staggering U.S. debt. That raises the possibility that tax rates will be higher in the future, he says, and is all the more reason to consider a Roth.
Upfront tax considerations
Whatever the reason, make sure you have cash to spare to pay the tax tied to the conversion, advisors warn. If you have adequate reserves but still feel uneasy, do the conversion in phases.
“For some people we’re doing some now and we’ll look and see where we are in the fall,” says Susan John, managing director and head of financial planning at F.L. Putnam Investment Management in Wolfeboro, N.H. That said, the benefit of converting when the market is beaten down, she says, is that it lets investors move a larger share of their portfolio over to a Roth for the same price. “When the markets recover, the converted shares will recover in a tax-free vehicle,” she says.
Would-be converters should also beware unintended consequences: triggering higher taxes. Remember that any pretax dollars you convert to a Roth are considered taxable income. Do the math on a Roth conversion to make sure it doesn’t bump you up to a higher tax bracket or, if you’re retired, affect your Social Security tax or Medicare premiums.
It’s important to get it right, says Stonich, since “un-doing” a Roth and recharacterizing it is no longer an option.
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