The benefits of Roth IRAs may be well known, but the IRS generally limits participation to low- and moderate-income workers. Eligibility for IRS contributions to Roth is currently $144,000 for single filers with a maximum income level. This prohibits many Americans from directly participating in Roth IRAs.
However, there are several ways to get around this income threshold, and we recently wrote about a popular one: the ability of high earners and business owners to contribute to their employer-sponsored retirement plans, such as a 401(k) plan, as long as it Offers Roth IRA terms. Read the full article, Roth Strategies for High Earners and Business Owners.
Another method is to complete a Roth conversion by taking money out of a (pre-tax) IRA and converting it into a Roth IRA, where all future earnings (subject to certain IRS rules) are tax-free. Doing this means declaring any amount withdrawn from a pre-tax IRA as income and paying income tax on it before investing it in a Roth IRA.
Paying income tax now with the hope of a tax-free gain later is particularly attractive to young people or those who will retire in a higher tax bracket. Note: You can convert the full amount of the IRA and pay taxes on funds held elsewhere. Everyone’s situation is unique, but this is generally the recommended course of action, provided other funds are available for liquidity needs, etc. Also note that switching may actually increase your marginal income tax rate, so be sure to monitor it.
Much has been written about Roth transitions, so why is now a good time to (re)consider Roth transitions? The answer is because the recent market sell-off has reduced or eliminated one of the barriers to a Roth switch, the risk of a switch happening shortly before the market declines.
A few years ago, investors could “re-characterize” a Roth conversion, essentially giving investors a “redo.” Recharacterization allows investors to reverse or unwind a Roth conversion during events such as stock market declines. But the ability to recharacterize disappeared on December 31, 2017, so once an investor transfers funds from a pre-tax IRA to a Roth, the investor is required to pay the full converted income tax. After a Roth switch, if the portfolio is subsequently reduced, the investor is taxed on the higher amount rather than the current portfolio value. This is not an ideal situation.
Some investors (and this advisor) were hesitant to switch IRAs and pay taxes on what may have been inflated asset levels when the stock market was on a near-endless rise. While the risk of further losses to the market and portfolio continues, the recent 20% +/- Nasdaq NDAQ decline may provide a more favorable entry point for the Roth switch. This is certainly a better time for most stock investors than six months ago when asset levels were quite high.
For those of you who are bullish on stocks and have been waiting for a more favorable point in time to convert your IRA, your time may have come.
This opportunity may not just belong to young people. Older investors who are considering similar or possibly higher tax rates in retirement may want to consider taking advantage of this opportunity, provided they don’t need to use the funds for +/- 10 years or more depending on the overall situation.
For those looking for a silver lining for the recent stock (and bond) market carnage, completing the Roth conversion may help ease tax pain later.
Each situation is unique and can be complex, especially when market returns, tax rates and future income levels are unknown. There are also some rules and other calculations to consider before completing a Roth conversion, so please consider all factors carefully and speak with your tax advisor before taking any action.