A Strategy for Your IRA in 2020: Roth Conversion
How can you use a downturn in the market to your advantage? You could position your assets so that your recovery in the market is tax-free. This may be a good time to consider converting traditional IRA money to a Roth IRA or making a Roth contribution if you can.
History tells us that the stock market will come back up
Stock market lows have consistently been followed by stock market recoveries. The chart below shows this pattern. As the market bottoms, it becomes an opportunity to position money for future growth. Utilizing a Roth IRA will allow future gains to be withdrawn tax-free in the future.
A Roth refresher
Roth IRAs allow you to contribute with after tax money. The gains and income that you earn on your money within the Roth accumulate without tax each year. When you withdraw the money, the entire withdrawal is tax-free if it is not a premature withdrawal (a withdrawal before age 59 ½).
A down market strategy
A Roth conversion is when you move money from your traditional IRA to your Roth IRA. While the overall stock market is down, it may be an appropriate time to move your depreciated assets so that they can recover in a tax-free account. This way you will not pay taxes on your investment earnings going forward.
How it works
A Roth conversion is treated as a withdrawal from your IRA and a transfer to your Roth IRA. This means that the amount of money withdrawn from the IRA will be taxed as ordinary income in the year that the conversion takes place. However, the 10% premature withdrawal penalty does not apply. When the money is transferred to the Roth it accumulates under the Roth rules going forward.
Utilizing a Roth IRA allows you to have control over your future portfolio withdrawals and may have a positive impact on your financial plan. Here are some advantages of moving traditional IRA money into a Roth:
Money in a traditional IRA will be taxed as ordinary income when it is withdrawn. Money withdrawn from a Roth IRA is tax-free. Using tax-free withdrawals from a Roth in retirement allows you to control your tax-rate while still meeting your income needs.
Traditional IRAs are subject to a required minimum distribution while Roth IRAs are not. Once you reach 72 years old, you are required to withdraw a certain amount of money and pay taxes on the withdrawal from a traditional IRA. This causes you to lose control of your withdrawal rate in retirement (you may have to withdraw more than you intend to). This also causes you to lose control of the tax bracket you fall into as your required minimum distribution may force you into a higher tax rate. Money in a Roth IRA is not subject to a required minimum distribution.
A tax-free account is more effective for large withdrawals in retirement. Sometimes it is necessary to take larger one-time withdrawals. This may be for a down payment on a home, a family vacation, medical bills, etc. In retirement, if the only money available for these large expenses is taxable as ordinary income, then they become unaffordable.
How much should you convert?
The amount you should convert will vary based on your financial plan. It is important to consider your current income range. I typically recommend evaluating where you fall within the current marginal tax brackets and then fill up your current tax bracket. Here is an example:
As you can see from the image, a married couple earning $100,000 would be in the 22% tax bracket. The next bracket is at $168,401. This means that the couple could earn an additional $68,400 at the same tax rate that they are currently in. Filling up the bracket means that the couple would convert $68,400 of IRA money to Roth. This conversion would be taxed at their current rate, but would not move them up into the next tax bracket.
If you are projecting that this year will be a down year as far as your personal income, then you may want to consider using the lower tax rate for a Roth conversion.
You can also make Roth contributions
Roth conversions are not treated as contributions. This means that you can still make a full contribution to your Roth IRA if you meet the income requirements. Making consistent periodic contributions to your Roth IRA is a great way to dollar cost average into the market and again take advantage of low valuations.
Here are the contribution rules for 2020:
Annual contribution limit: $6,000
Over 50 years old: $1,000 catch-up contribution for a total of $7,000
Keep in mind, there are income limits to be eligible to contribute to a Roth IRA. These income limits do not apply to Roth conversions.
When considering any withdrawals or changes to your individual retirement accounts, it is important to discuss these decisions with your financial team. Changes to your financial plan, income and tax strategy should be reviewed with a financial planner and tax adviser before you make any decisions.
Please contact us with any questions that you have and we will be happy to review how a Roth conversion fits into your financial plan.