Tax Tip of the Week | Fight the Bear Market With a Roth IRA

“Hard work keeps the wrinkles out of the mind and spirit.”

                                  -Helena Rubinstein, American-Polish Businesswoman

 This week’s article takes a look at an animal investors might prefer to come face to face with in the wild than in the stock market: the bear. One silver lining of a sinking stock market is that it puts Roth IRA conversions on discount. This article provides a highly detailed comparison of the tax implications of traditional IRAs and Roth IRAs so that you can determine if a conversion can help you make the most of this downturn.
 
-Jordan Bradstreet
 
Roth IRAs are the best retirement plans to have, and this year’s market declines have put them on sale
 
Attention, retirement savers: Don’t get spooked by the bear market and forget about doing a Roth IRA conversion. With prices down, the upside could be terrific.

On the other hand, don’t rush into a conversion willy-nilly. This move is never appropriate for some people and not a sure thing for anyone.

“A Roth IRA is the best retirement plan to own; the big question is how much you have to pay to get it,” says Natalie Choate, a tax lawyer in Wellesley, Mass., who has long specialized in retirement accounts and done several conversions herself.

The reason to consider a conversion in a bear market: When the value of assets like stocks and funds fall, the taxes on conversions to Roth IRAs often drop as well, and there’s greater potential for asset growth and withdrawals that are tax-free.

A growing number of taxpayers have opted for Roth IRA conversions in recent years. Taxpayers reported 892,000 Roth conversions totaling nearly $17 billion in 2019, according to the latest IRS data. That’s about twice the levels of 2014, when 489,000 taxpayers converted about $8 billion. Conversions have been especially popular with taxpayers earning $200,000 to $500,000.

So let’s review what’s involved. A Roth conversion entails moving assets from a traditional IRA to a Roth IRA. Both accounts allow tax-free growth, but there are key differences.

With traditional IRAs, the contributions are often tax deductible, and withdrawals at age 59 ½ and older are fully taxable at ordinary-income rates like the ones for wages. Traditional IRAs often include rollovers from workplace plans like 401(k)s, so these IRAs can be very large.

With Roth IRAs, the contributions are in after-tax dollars, but withdrawals can be tax-free. In addition, Roth owners don’t have to take required withdrawals during their lifetime, while traditional IRA owners must start them at age 72. The required withdrawals from traditional IRAs rise over time, depleting the account.

Under current law, savers can convert traditional IRAs to Roth IRAs by moving assets from one account to the other and paying income tax on the transfer. This tax bill can be stiff, and there’s no assurance future growth will compensate the saver for having accelerated taxes. But converting when prices are down puts more income beyond the reach of Uncle Sam if prices recover and grow.

Ms. Choate says she has experienced both good and bad outcomes with her own Roth conversions. Her first one was of a basket of blue-chip stocks worth $100,000 in 2010 and has paid off handsomely—dividends alone have added $100,000 to the total. But another, of a beaten-up energy stock she liked, flopped because the stock went to zero. So she paid tax she wouldn’t otherwise have owed.

Many factors matter when determining whether a Roth conversion makes sense. To help savers decide, here are key issues.

Tax rate at conversion vs. tax rate at withdrawal

If the tax rate on the Roth IRA conversion is lower than the expected rate when the assets would be withdrawn, that weighs in favor of a conversion. If the rate at conversion is higher than the expected rate at withdrawal, that weighs against.

So savers should try to do Roth conversions in lower-tax-rate years. For example, a conversion could make sense for an older person who has retired but hasn’t started taking required IRA payouts, or for a young worker who has IRA or 401(k) savings who pauses work to go back to school.

For this reason, advisers often recommend doing partial Roth conversions over several years to avoid income that pushes a saver into a higher tax bracket.

Asset prices

The lower prices are, the lower the tax bill on a Roth conversion often is. That’s a boon—as long as prices recover and grow.

Spokespeople for Fidelity Investments, Charles Schwab Corp., and Vanguard Group confirm that they allow investors to select individual holdings from traditional IRAs and convert them to Roth IRAs “in kind.” So investors who want to transfer a beaten-down holding don’t have to sell it, transfer cash, and re-buy the holding in the Roth account.

Ability to pay the tax bill with ‘outside’ funds

Savers who can’t pay the tax bill on a Roth conversion with funds outside the account probably shouldn’t convert, say specialists. Paying the taxes with IRA assets shrinks the amount that can grow tax-free.

The ‘widow’s penalty’

The year after a spouse dies, the survivor can no longer file jointly. As a result of being a single filer, the survivor’s tax rate often rises even if income has dropped.

If this is likely, the couple may want to do Roth conversions to avoid higher tax rates for the surviving spouse.

State and local taxes

State and local taxes on traditional and Roth IRA contributions and withdrawals vary greatly, so take them into account when analyzing a conversion.

For example, a soon-to-be retiree who plans to leave a high-tax area in California or New Jersey for a low-tax one in Florida or Nevada will likely want to move before doing a Roth conversion.

And watch for quirks. Attorney Mark Klein of the Hodgson Russ law firm notes that while New York is known as a high-tax state, it allows many residents who are 59 ½ or older to skip state income tax on the first $20,000 withdrawn from a traditional IRA annually. This benefit can lower taxes on a Roth conversion.

Leaving an IRA to nonspouse heirs

Leaving Roth IRAs to nonspouse heirs such as grandchildren will often provide them more flexibility than leaving them traditional IRAs.

Both types of accounts often must be emptied within 10 years, but heirs of Roth IRAs can wait until the end of the term to withdraw their tax-free funds.

Heirs of traditional IRAs must take taxable payouts annually if the owner died after age 72.

If an IRA owner lives in one of the few states with estate or inheritance taxes or will owe federal estate taxes, leaving a Roth IRA instead of a traditional IRA to heirs could reduce death duties.

Potential for future large deductions

Savers who could have outsized tax deductions in retirement—such as for nursing-home costs—should remember that such deductions can shelter withdrawals from traditional IRAs. A Roth conversion of such amounts now could bring an unnecessary tax bill.

Potential to minimize other taxes

Having tax-free Roth IRA withdrawals helps some taxpayers minimize other taxes or surcharges, such as Medicare Part B and Part D premiums that rise as income does. This can also help filers stay below the $200,000 (singles) or $250,000 (joint filers) threshold for the 3.8% surtax on net investment income.

Age at conversion

Savers age 72 and older must take their required annual payouts before doing a Roth IRA conversion. That raises taxable income and makes conversions less attractive.
 
Credit Given to: Laura Saunders. Published June 24, 2022 in the Wall Street Journal.
 
 Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
 
This Week’s Author, Jordan Bradstreet
 
-until next week.