The benefits of a Roth IRA may be well known, but the IRS typically limits participation to low and moderate-income workers. The IRS eligibility for contributions to a Roth is currently a maximum income level of $144,000 for single filers. This prohibits many Americans from directly participating in a Roth IRA.
However, there are a few ways around this income threshold, and we recently wrote about a popular one: the ability for higher earners and business owners to contribute to their employer sponsored retirement plan e.g., a 401(k) plan, provided it offers a Roth IRA provision. 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 to a Roth IRA where all the future gains, subject to some IRS rules being met, could be tax-free. Doing this means declaring, as income, any amount taken from the pre-tax IRA, and making it subject to income tax prior to it being invested in the Roth IRA.
Paying income tax now, with the hope of having tax-free gains later, is especially attractive for a younger person or for someone who will retire in a higher tax bracket. Note: you can convert the entire amount of the IRA and pay taxes with funds held elsewhere. Every person’s situation is unique, but this is often a suggested course of action provided other funds are available for liquidity needs, etc. Also note that the conversion could actually raise your marginal income tax rate, so be sure to monitor that as well.
There have been many articles written about Roth conversions, so why is now a good time to (re)consider a Roth conversion? The answer is because the recent market sell-off has reduced or removed one of the barriers to a Roth conversion, and that is the risk that a conversion occurs shortly before a market decline.
Several years ago, an investor could ‘re-characterize’ a Roth conversion basically giving the investor a ‘do-over’. A re-characterization allowed an investor to reverse or unwind the Roth conversion in the event, for example, the stock market declined. But the ability to recharacterize disappeared on December 31, 2017, so once an investor moves money from a pre-tax IRA to a Roth, the investor is subject to income tax on the full, converted amount. After the Roth conversion, if the investment portfolio subsequently reduces, the investor pays tax on a higher amount rather than the current portfolio value. This is not a desirable situation.
When the stock market was on its virtual unending run upwards, it created a hesitancy among some investors (and this advisor) to convert an IRA and pay tax on what may have been a bloated asset level. While the risk of further market and portfolio losses continues, the recent 20% +/- drop in the NASDAQ
For those optimistic on stocks, and who have been waiting for a more favorable point in time to convert an IRA, your time may have arrived.
This opportunity may not just be for young people. Older investors who are looking at a similar, or potentially higher tax bracket in retirement, may want to consider capitalizing on this opportunity provided they won’t need to access these funds for +/- 10 years or more depending on their overall situation.
For those looking for a silver lining to the recent stock (and bond) market carnage, completing a Roth conversion may help save tax pain later.
Each situation is unique and potentially complicated, especially with market returns, tax rates, and future income levels unknown. There are also rules and other calculations to consider before completing a Roth conversion, so please carefully consider all factors and talk with your tax advisor before taking any action.