iStock-1090754116.jpg

Making Lemonade

Recent large stock market swings bring about possible benefits by revising our personal tax strategies. For investors with large stock holdings in an IRA, the brutal market reset could make the math of a Roth IRA conversion even more compelling. Now could be a particularly good time, because a decline in value would cause a smaller tax bite to occur.

Because Roth IRAs are such powerful compounders, the IRS precludes high income individuals from contributing. But the Roth IRA rules don’t have an income test for conversions, so highly compensated individuals can actually obtain a Roth by converting a regular IRA and paying the tax. Doing so in a steep market decline could add a silver lining to the pain of recent losses. When stocks do recover, the increases in value would then be tax free.

Since Roth IRAs have no taxes on future compounded value, investors must use after tax dollars at inception. That means no deduction for contributions, and conversions must be cleansed of their pending tax liability that has thus far been deferred in a regular IRA. Roth IRAs also have no required minimum distribution (RMD) feature, so older investors might find a conversion timely since the RMD rules will eventually force an investor out of their tax-deferral in a regular IRA anyway. This is less true for the current tax year since the government’s COVID-19 response appears to waive RMD requirements for 2020. You can expect those to resume however.

Recent other rule changes had already put Roth conversions on the front burner. The recently passed SECURE act leveled the playing field a bit by no longer allowing “Stretch IRAs.” A Stretch could occur when a non-spouse beneficiary inherited an IRA and could use their own age to possibly slow down RMDs and stretch the life of the IRA another generation or more. The SECURE act stops the Stretch at ten years and requires depletion by then. Compare that with longstanding rules in Roth IRAs that have always required depletion in five years. This makes the Roth more competitive than before the SECURE act by reducing the previous Stretch deferral advantage of a regular IRA.

There are also tax benefits with Roth IRAs held by large estates. While joint estates are exempt from estate taxes up to about $23 million in 2020, large untaxed IRAs can get hit hard when deferred taxes are calculated as part of the estate total. This could mean 80% or more of stacked taxes on a regular IRA in a large estate. With a Roth having pre-paid its tax liability, there’s likely a second round of benefits possible in large cases.

We don’t give tax advice, so check with your tax professional to see if any of this makes strategic sense for your situation.