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With the recent market downturn this may be a great time to chip away at some Roth conversions. Market corrections and bear markets while stressful can create long-term tax planning opportunities. Think of this as the market is creating a sale on Roth conversions. When you convert to a Roth from a Traditional IRA or pre-tax 401(k) account the amount converted is subject to ordinary income tax. If the market is down 15%, then the cost of a Roth conversion is 15% less on the same shares that you will transfer or redeem and then repurchase in the Roth account.

Anyone with a Traditional IRA or a non-active 401(k) can do Roth conversions. There is no income limit on what are know as “back door” Roth’s. Some plan sponsors are now permitting “in-plan” Roth conversion for its active participants. Eventually you will be paying ordinary income tax rates on your pre-tax accounts whether you take the distributions voluntarily or are forced to take them through the Required Minimum Distribution (RMD) rules. The normal calculus to making a pre-tax deferral has been “am I in a lower tax bracket when the contributions were made versus the tax bracket that I will be when I take the distributions?” For the average worker, this was a reasoned decision. For high-net-worth taxpayers, this is often not the case. With tax brackets at historic lows now, they are scheduled to revert to the higher 2017 rates beginning in January of 2026 unless Congress acts to extend or amend the current tax rates. It is doubtful that any future tax changes will be to lower the tax rates.

Similar to portfolio diversification, you need to make tax diversification part of your financial plan. For most taxpayers it would not be tax efficient to convert all the pre-tax accounts to Roth. While having some assets in Roth will provide the tools needed to what we call tax bracket management while in retirement. The way we do this for our clients is we know how much money they need each year for living expenses and extras as defined in their financial plan. From there we look at the assets held in various tax buckets. The amount needed for withdraws is then selectively taken from pre-tax and after-tax accounts. Roth funds are a specialized tool because we do not have to navigate through ordinary income taxes from pre-tax accounts, and capital gains taxes from after tax accounts. Roth assets can prevent a taxpayer from breaching a certain tax bracket which will force a higher marginal tax rate, this allows us to be more tax efficient as we are liquidating assets needed for the retirement spend-down cash flow.

Market downturns are a great time to advance your tax diversification strategy within your financial plan. We normally recommend doing Roth conversions throughout the year by employing dollar cost averaging. This can be beneficial during volatile market conditions. Market downturns create opportunities to be more aggressive since the market is running a sale and no one know for sure how long the sale will last. For any Roth conversion strategy to be effective, be aware of the 5-year Roth rule. To avoid taxes on the earnings of any converted amount it must remain in the Roth account for 5-years to achieve tax free distributions. Even if you have multiple Roth accounts, the pro-rata basis of the contributions or conversions made within the most recent 5 years is a factor.

Estimated tax payments are needed to cover the ordinary income the Roth conversion generates. These tax payment(s) should come from idle cash, and not from any part of the IRA distributions being converted. This will keep the entire conversion amount invested for future growth. The goal here is to achieve a return on the “tax payment” investment that is being made with the conversion, otherwise the break-even hill could be too steep. The 10% penalty for distributions from an IRA prior to age 591/2 are waived for Roth conversions, but be careful with the waiver. If any of the IRA/401(k) funds being distributed are used to pay the ordinary income taxes due (or for any other purpose), then this portion of the distribution is not subject to the waiver of the 10% penalty. For example, let’s look at a $25,000 Traditional IRA distribution was taken and $20,000 was immediately transferred to a Roth IRA, while the remaining $5,000 was used to pay taxes on the conversion. The $5,000 is subject to ordinary income taxes for everyone. Whereas taxpayers under the age of 591/2 would also be subject to the 10% premature distribution penalty on the $5,000.

Looking beyond the 5-year Roth rule, which is a nit for long term investors, the real benefit of a Roth strategy is that distributions are tax free in retirement. This has the effect of lowering a taxpayer’s adjusted gross income (AGI) which may allow for larger deductions that are subject to AGI limitations, such as medical deductions and charitable contributions. Additionally, Roth distributions in retirement are not included in the means tested Medicare Part B premiums that you will pay, it uses your AGI from 2-years prior. Depending on your investment time horizon and the appreciation of the account the greatest benefit could be not paying any tax on the compounded earnings the investments in the Roth account generate. This could be a substantial savings especially if the Roth account is invested aggressively with a risk offset in the pre-tax account. We refer to this strategy as holistic tax sensitive portfolio management, which is a very tailored approach for each of our clients.

Lastly, there are no required minimum distributions (RMDs) from a Roth IRA. The RMD rules do apply to Roth 401(k) accounts, although these RMD’s can be rolled over tax free to a Roth IRA. Since the SECURE Act eliminated the stretch IRA which was a popular estate planning strategy for transferring wealth to younger generations tax deferred, this makes bequeathing a ROTH IRA more valuable to your heirs. Your beneficiaries can leave the money in an inherited-ROTH IRA for up to ten years tax deferred, and then liquidate it tax fee.


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