By Linda Kotis
The stock market has been full of crazy swings this year. Your retirement accounts were buoyed by the 1.2% gain in the Dow Jones Industrial Average on January 8. Then you cringed as account values bounced around in March with a 333 point drop. You nearly fainted as the Dow plunged again this summer – 500-plus points on August 21! While the close of the year has offered some recovery, you haven’t yet recouped the value you started with at the first of the year.
The Bright Side to All This Instability:
Your retirement account’s weak performance offers the opportunity to save some taxes, both now and in the future. This can be achieved through converting your traditional Individual Retirement Account (IRA) to a Roth IRA. Like a traditional IRA, the assets in a Roth IRA grow tax-free while remaining in your account. Unlike a traditional IRA, once you start taking out your money, Roth distributions are tax-free.
If you participate in a traditional 401(k) plan at work, you may also be able to convert some or all of your pre-tax (or after-tax) contribution account balance to Roth 401(k) contributions. This is the case so long as your employer offers a Roth 401(k) plan and permits the conversion. Therefore, you need to check with your plan administrator to determine if this is a viable option for you. While an in-plan Roth rollover provides similar tax benefits, you should be aware that rules affecting distributions, among other things, may differ from those of a converted Roth IRA.
The Candidates for Roth IRA Conversions:
Anyone can convert a traditional retirement account to a Roth IRA. There is no income limit or other restrictions on the account owner. The owner does have to pay income taxes on the account’s value on the date of conversion. But the result is an investment account that would never again be subject to income taxes. And no minimum distributions are required for your entire lifetime.
Hypothetical Scenario: Take Charlotte, a 45 year-old independent software developer. She left a major tech company four years ago to develop new apps related to food cable TV ventures. After her departure, she rolled over her account from the company 401(k) plan to a traditional IRA. The bad news is that her traditional IRA has lost $25,000 in value this year. (It was worth $425,000 at the start of 2015; it’s now down to $400,000.) The good news is that by converting now, she’ll pay taxes on 6% less value than she would’ve paid on January 1, 2015. At a 39.6% tax rate, she’ll save $9,900 in federal income taxes ($425,000 x 39.6% = $168,300 compared to $400,000 x 39.6% = $158,400).
The account grows tax-free and when Charlotte takes distributions from her converted Roth IRA in the future they won’t be included in her income or be taxed. This also gives Charlotte some tax diversification in her retirement portfolio. She has other traditional IRAs to which she has made contributions that she’s not planning to convert.
A Few Things to Consider Regarding Conversion:
- Will your income tax rate be lower now, or during your future retirement years? For some account holders, this makes a difference. Postponing the tax bill to later years when you’re in a lower bracket, and paying taxes on distributions at the time you take them, could mean substantial savings. This assumes, of course, that tax rates now in effect will be those in effect in the future. Given that rates are now at an historic low, it’s also possible you may be in a similar bracket at retirement. Or one that’s even higher.
- Charlotte can’t see herself retiring early, and she doesn’t plan to touch the IRA until she’s at least 70. So the tax bracket issue is not really a consideration. Instead, she sees the benefit of 25 years of tax-free growth.
- Charlotte is also considering turning this income tax-savings vehicle into an estate-planning vehicle. Because no distributions are required during lifetime, Charlotte can let the account continue to grow without being diminished by required minimum distributions (RMDs) and ultimately transfer the asset to her family. By leaving the converted Roth IRA to her husband Harry, he can rollover the Roth and treat the account as his own. Then he’s not required to take RMDs during his lifetime either. Upon Harry’s death, he’ll name their son Chad as beneficiary, and Chad can take the Roth distributions slowly over his lifetime. The account will then be able to grow tax-free for decades more.
- Do you have a source of funds to pay the income taxes, other than the converted funds? This is very important if you’re under age 59 ½. If you use a portion of the IRA to pay the tax bill, the payment is treated as an early distribution of the traditional IRA. You’ll wind up paying a 10% penalty on taxes owed. This could really gut your tax savings.
- Fortunately for Charlotte, she sold one of her apps for a tidy sum in 2013 and has a ready supply of cash. Even if Charlotte were over 59 ½ and the penalty didn’t apply, using other funds for the taxes enables her to retain more assets in the Roth IRA that will grow tax-free.
- Are you converting an IRA that owns different kinds of assets? Then, as part of the conversion strategy, consider creating separate accounts to reflect separate asset classes. This positions you in case the IRA declines in value further, and you decide you want to undo the conversion, or “recharacterize.”
- Charlotte’s $400,000 traditional IRA holds $100,000 in international bond funds and $300,000 in small cap funds. Suppose that after Charlotte decided to convert to a Roth IRA, the bond funds decline further. Fortunately, she created two accounts – one to hold the converted bond funds and one to hold the converted small cap funds. Charlotte will be able to recharacterize only the Roth IRA account owning the bond funds, so that she won’t be paying taxes based on the account’s higher value on the conversion date.
- Provided Charlotte recharacterizes the entire balance of the bond funds account, she won’t owe any income tax on the conversion of the assets in that account. By putting the bond funds and small cap funds into separate accounts, Charlotte will eliminate all the taxes due on the bond funds conversion. Now there will only be taxes due on the conversion of the small cap funds account.
- Make sure that if you do decide to recharacterize, you implement your recharacterization within the required timeframe.
- Charlotte converted her traditional IRA on November 13, 2015. She has to wait 30 days after the conversion to recharacterize but must accomplish it no later than October 15, 2016.
Some Final Thoughts:
Other factors affecting conversion to a Roth IRA include the timing for taking distributions from the account (five years after the account is opened or beginning at age 59 ½). You should consult your estate planning attorney, tax professional, and/or financial advisor about the specifics of your situation before you decide to convert.
*The author is an attorney practicing trusts and estates law in the D.C. office of Ivins, Phillips & Barker, and wishes to thank her colleagues Brenda K. Jackson-Cooper and Benjamin L. Grosz for their assistance with the article.
This article has been prepared for informational purposes only with no warranty as to its applicability to a particular set of circumstances. The article is not intended and should not be considered to be legal advice and does not create an attorney-client relationship with any reader of the information. This article is based on federal tax law in effect as of the date written and the law may change. Readers should not act upon any content without obtaining appropriate advice in the relevant jurisdiction.