Dear Mr. Market:
The wild ride continues! As we have addressed before, the nasty trifecta of oil, China and the Fed continue to hammer the markets. Moments like these can make or break portfolios and dramatically impact your future goals. Most investors have an IRA that they either have been funding or perhaps a rollover IRA from a previous 401(k) that sits on the sidelines and they periodically, if ever, look at. Volatile markets like this present an opportunity with these IRAs that could prove to be very advantageous!
“It’s almost like a half-off sale. If your IRA has dropped significantly in value, not only will the cost (of converting to a Roth IRA) be minimal, all the upside will be tax-free. Now is the time to strike!” – Ed Slott, The IRA Advisor
*** Before we dive into the specifics of converting an IRA it is important to note that we encourage you to consult your CPA or Tax Advisor to discuss in detail. We are not tax advisors and (unless you are a client) we do not know your specific financial or tax situation.***
The decision about converting an IRA to a Roth IRA comes down to three key factors: taxes, cost and time.
Taxes: If your tax bracket is lower today than it may likely be in retirement (no we do not have a crystal ball!), then you might want to consider a Roth conversion. Also if your account has decreased in value due to the market you will pay less in taxes based on the value of the amount converted.
Cost: You will have to pay taxes on the amount converted, but it is also important to consider if the conversion could bump you into a higher tax bracket. Keep in mind that a conversion is not an ‘all or none’ scenario; you can do a partial conversion of your IRA. Roth IRA Conversion Analyzer tool.
Time: Individuals that have a longer time horizon will generally benefit the most from a conversion.
Key benefits of a Roth IRA…
- Withdraws are tax-free
- No required minimum distributions
- Estate Planning tool – leave tax-free money to your heirs
- Can serve as a hedge against future tax increases
- Reduce Medicare surtax – Roth IRA withdraws are not considered toward modified adjusted gross income (MAGI) like traditional IRAs and 401(k)s.
- Access to contributions – you can withdraw contributions (you’ve already paid taxes on them) although earnings may have restrictions.
- Contributions – you can contribute as long as you collect a paycheck or have 1099 income but there are income limits. With traditional IRAs you can’t contribute once you reach 70 ½.
In the past high wage earners were not allowed to take advantage of converting to a Roth IRA as there was a $100,000 income limitation. This is no longer an issue as the IRS has changed the rule, there currently is no income cap in place.
We’ve discussed the basics but let’s take this to another level, especially when you consider the volatility we are seeing in the market. What if the market continues to drop? Are you then locked in paying taxes based on the value when the conversion took place? The simple answer is yes…BUT there is a caveat here to keep in mind!
The IRS allows for a ‘recharacterization’ of Roth IRA conversions. Essentially this is your chance to take advantage of a further declining market as it allows you to ‘undo’ the conversion. They allow you to do this until April 15th following the year of the conversion or until October 15th if filing with an extension. Here is where it can get a little tricky if you are doing another conversion of the recharacterized amount. The IRS mandates that you wait until the later of:
- 30 days following the recharacterization, or
- The year after the conversion
There are many moving pieces to be considered when doing a partial or total Roth IRA conversion but the benefits can have a profound impact on your long-term financial plan. Each individual’s circumstance is unique but this is a strategy that everyone should consider! As you are getting your tax forms together we would suggest adding this to the list of questions that you have for your tax advisor.