Two questions come to mind as we encounter challenging markets and periods of uncertainty: what can we control, and where do opportunities exist?
A well-positioned portfolio with a sound investment approach will weather this market shock, but the savvy planner will not stop there.
One of the things you can attempt to control is taxes. For non-retirement accounts, actively loss harvesting a portfolio can provide a tax benefit to investors. For those with traditional retirement accounts, also known as pre-tax or regular, there is another tax opportunity to consider.
Market volatility has had an impact on retirement account balances, particularly for those with long-time horizons and more aggressive positioning. But with this sour volatility comes the opportunity to make some lemonade by considering a Roth conversion strategy.
2020 Market Volatility
- 10 Lessons From the Financial Crisis That Stand the Test of Time
- Timeless Investment Truths in Uncertain Times
- Revisiting Your Portfolio Strategy As Bear Market Looms
- The Market Is Down. What Should You Do?
Roth conversions, particularly when done in low tax environments and on depressed account balances, can pay huge dividends down the road in the form of reduced income-tax burdens.
A Roth conversion allows a traditional retirement account owner to transfer—or “convert”—some or all of their accounts into Roth dollars. Whereas traditional retirement accounts are attractive because they can offer an immediate deduction, and therefore immediate tax benefit, Roth accounts are attractive because they can offer tax-free withdrawals.
Once you hold a Roth for five years and are age 59½, all withdrawals are tax- and penalty-free. And further, there are no required minimum distribution (RMD) obligations during the lifetime of the account holder. However, beneficiaries who inherit Roth accounts must take RMDs.
Essentially, there is a choice to make between paying taxes now or paying taxes on withdrawals in retirement. Why might paying taxes now be advantageous? A few potential reasons:
- Tax rates are low by historical standards;
- With depressed market prices, paying tax now and realizing market recovery in Roth accounts has future upside potential;
- Unfortunately, for many, 2020 may prove to be a lower income year than 2019 or years out into the future.
If some or all of these factors apply to your situation, a Roth conversion strategy may be a way for you to make lemonade with the lemons this market volatility is throwing our way.
Roths have benefits beyond merely providing tax-free growth for beneficiaries—though that is not a benefit to underestimate. In retirement, people with Roth accounts can take tax-free withdrawals to supplement taxable income and stay within a lower tax bracket to accomplish things like obtaining healthcare subsidies, reducing the taxable portion of Social Security benefits, or reducing or altogether avoiding the surcharges on Medicare premiums that kick in at higher income levels.
A note for those subject to RMDs: The CARES Act suspends the RMD requirements for 2020 for IRAs under new Code Section 401(a)(9)(l). Investors who would otherwise be subject to RMDs are not required to take a distribution from their IRA this year. Instead, that income can be realized in the form of a Roth conversion, which will secure tax-free growth forever.
Matt Mormino, CFP® serves as an advisor at Brighton Jones.