This is a year of market and economic turmoil. Don't let that distract you from your long term goals and making savvy money moves. Let's learn about one tax smart opportunity that could be right for you:
The Roth Conversion
First, what IS a Roth conversion?
A Roth conversion moves your money from your Traditional IRA into a Roth IRA, which can yield long term tax benefits. The COVID crash in stock prices means income tax that you'd pay on traditional IRA conversions to a Roth IRA is much lower than it would have been pre- stock market correction.
Wait, what's the difference between a Roth & a Traditional IRA, again?
A Traditional IRA grows tax deferred (meaning you will eventually pay taxes on the amount within your Traditional IRA when you pull it out for income in retirement). A Roth allows your after-tax dollars to grow tax free for retirement.
What does this mean for dollars you might convert to your Roth from a Traditional IRA?
In the year you convert assets from a Traditional IRA, you will have to pay taxes on those dollars in order for them to grow tax free in future years. Assets you shift from a Traditional IRA to a Roth become taxable. It essentially looks like you made that money as ordinary income on the year of the Roth conversion. Keep in mind: you will have to pay taxes on the money you've stowed in your 401k and Traditional IRAs either now (via a conversion) or later (when you pull as income in retirement). The Roth conversion means you're paying taxes on that money now to avoid having to pay them later.
But, why would I WANT to pay taxes before I have to?
A Roth conversion entitles you to tax free withdrawals from your Roth IRA forever, once you have had the account for 5 years and reach 59.5 years old. Forever is a really long time, especially if you plan to use a Roth IRA to leave a legacy for kids or a spouse....But, even if it's just you living your best life: it could mean a lot of tax free income, for a lot of years.
When is the best time to do a Roth conversion?
Short answer: For a lot of people, now. Long answer: See below.
1) In a year in which you will fall in a lower tax bracket than usual
For example, if you've been laid off, you are unemployed, or you won't get your usual bonus, you won't have as much income this year and as a result, you will fall in a lower tax bracket than normal.
2) When your Traditional IRA is down in value
In a year like this year, you may have existing assets in your Traditional IRA that are down in value, especially when compared to 2019 year-end. You can do what's called an "in kind" conversion, meaning, you have the ability to move existing assets that are down in value to your Roth IRA without selling out of them and pay taxes on the lower dollar amount now, so that those investments can grow tax free until you retire.
Consider this: if your Traditional IRA was worth $100,000 on January 1st, 2020 and its value declined along with the market (let's use the DJIA as an index we are tracking, for example), then your IRA is still down. If your portfolio was tracking the performance of the DJIA, it would be valued at approximately $82,800 now. If that dollar amount was converted from your Traditional IRA to your Roth IRA today, you'd pay tax on $82,800 rather than $100,000 and you could continue to hold the same investments while they rebound tax free in future years. For further detail on market performance year to date, I give you...CHARTS. Skip this portion if you're not a chart person and proceed to 3).
The 2020 Year To Date performance (versus 2019 full-year) performance of the market broken down by the 11 market sectors (as of the close on 5/14/20):
2020 YTD 2019 Final
- Info Tech +1.4% +48.0%
- Healthcare -2.4% +18.7%
- Consumer Disc -5.5% +26.2%
- Communications Svc -6.4% +30.9%
- Cons Staples -10.0% +24.0%
- Utilities -14.3% +22.2%
- Materials -17.8% +21.9%
- Real Estate -19.9% +24.9%
- Industrials -26.8% +26.8%
- Financials -31.3% +29.2%
- Energy -40.2% +7.6%
Source: Bloomberg L.P.
Past performance is no guarantee of future results.
And, for your viewing pleasure, here is the 2020 YTD (versus 2019 full-year) performance of the major U.S. equity indices (as of the close on 5/14/20):
2020 YTD 2019 Final
- S&P 500 (SPX) -11.7% +28.9%
- Nasdaq Composite (COMPX) -0.3% +35.2%
- Dow Industrials (DJI) -17.2% +22.3%
- Russell 2000 (RUT) -25.8% +23.7%
Ok, why else might I consider doing a Roth Conversion this year?
3) Early in the tax year
You don't have to pay personal income taxes for income earned in 2020 until 2021, so converting early in the tax year gives you more time to make sure you have enough funds set aside to cover taxes. Alternatively, when you convert, you can also set tax withholding on your conversion, allowing your advisor to withhold some taxes for you (although it is difficult to determine your exact tax bracket early in the year, you can estimate and withhold to reduce the tax burden on the back end in 2021).
4) You've left a job and would like to organize old work retirement accounts
When you leave a job, you have several options to consider, one of them could be a Roth conversion. Keep in mind: you don't have to convert an entire Traditional IRA or 401k at once. You can do so little by little over several years to lessen your annual tax burden. A Roth conversion also isn't the ONLY option for what to do with your old 401ks, so it is important to meet with an experienced, fiduciary financial advisor and consult with your tax professional before making any major decisions that could impact your retirement.
How do I know if a Roth Conversion is right for me?
1) You like the idea of your investment account growing tax free
2) You want your taxable income to be lower in retirement
3) You want to avoid required minimum distributions (the requirement to take distributions from your Traditional IRA and pay taxes on them by age 72 in retirement). Maybe you want to leave a tax free account as a legacy for your children.
4) You think your income and tax bracket may be higher in retirement
A Roth Conversion could be wrong for you if:
1) You lack funds needed to pay taxes on converting from a Traditional IRA to a Roth IRA
2) You will need the money from your Traditional IRA in the next 5 years (if you are very close to retirement, this could be the case)...How close you are to retirement will also impact the benefit versus drawbacks of converting to a Roth IRA. So, again, very important to consult with an experienced financial advisor and your tax professional.
3) If doing a conversion would bump you into a potentially higher marginal tax bracket (if you are married and filing jointly, consider what your joint household income is)
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