The start of 2016 has been scary, no doubt about that. But savvy investors may find a bright side: a chance to trim the tax bill when converting a traditional IRA or 401(k) into a tax-free Roth.
And those who converted last year and suffered buyer’s remorse have a second chance. Through a recharacterization, they can undo last year’s conversion, then convert again under today’s more favorable conditions — again, trimming their tax bill.
“Typically, the driving force behind a Roth IRA [or 401(k)] conversion is to take advantage of the tax-free growth and withdrawal features of a Roth,” says Michael Jackson, financial advisor with D.A. Davidson & Co. in Spokane, Washington. “A market correction like we have just experienced makes this strategy very enticing for investors … to convert the lower-priced assets now and catch the ultimate rebound in the markets, tax free.”
To begin at the beginning, there are two types of IRAs and 401(k)s. With the traditional varieties, the investor can get an income tax deduction on most contributions, and tax on annual gains is deferred until money is withdrawn, when it is taxed as income. (IRA contributions may or may not be tax deductible, based on a number of factors.)
Roth IRAs and Roth 401(k)s don’t allow deductions on contributions, but all qualified withdrawals are tax free, including the original contributions and any investment gains.
Investors who wish they had a Roth can shift holdings from a traditional account into a Roth account, but must pay any tax that would be due if the transferred funds were simply withdrawn. The change could pay off, for example, if you think your tax rate will be higher in retirement than it is now, since you could pay tax at today’s low rate to avoid tax at a higher rate later.
The lower the tax bill, the more sense a conversion makes, which is why this may be a good time to consider this move. Because many IRA and 401(k) holdings have lost value this year, the tax bill on a conversion could be cheaper than when account values are higher.
Imagine an investor with a fully taxable traditional IRA that was worth $100,000 this time last year. Converting then could have triggered a $25,000 tax bill, assuming a 25 percent tax bracket. If the account were worth just $90,000 today, the tax bill would be $22,500.
Converting an IRA is a fairly simple process done through the bank, broker or fund company that has the account. Most offer online calculators for figuring whether a conversion will pay.
Converting a 401(k) can be a bit more complicated than converting an IRA. Many employers allow participants to make this move, but if yours doesn’t, you may have to wait until you’ve left the company. At that point you can do a 401(k) rollover, which is a tax-free transfer of the 401(k) assets into a traditional or Roth IRA.
There are no income limits or other restriction — anyone can convert. The younger you are, the more likely it will make sense, since the Roth account would have many years to compound tax free.
A recharacterization is done with the firm that has the Roth IRA account, and must be completed by the filing deadline for the tax return for the year the conversion was performed. Since this includes filing extensions, it generally means by mid-October of the year after the conversion (October 17 this year).
Once the account has been turned back into a traditional IRA, it can be left that way or converted again once 30 days have past and it is no longer the same tax year as the original conversion. Roth 401(k)s cannot be recharacterized, but you can recharacterize a Roth IRA that started life as a traditional 401(k).
“It makes sense to recharacterize if the value of the investments converted has declined, and to reconvert after meeting the waiting period, assuming asset values are still down,” says Amy L. Shappell, senior financial advisor with Juetten Personal Financial Planning in Bellevue, Washington.
Unfortunately, the converted sum is added to the taxpayer’s income for that year. So not only is the money taxed, it can lift the investor into a higher tax bracket. To avoid that, the investor can break the conversion into smaller pieces done over several years, says Davy Knox, client success champion at Ubiquity Retirement + Savings of San Francisco.
“This will allow you to plan and manage the new tax situation the conversion will put you in more easily,” he says.
Obviously, this is a tricky decision. In most cases, a conversion is a long-term strategy not based on temporary market conditions. Today’s depressed stock prices would simply put a cherry atop a move that already looks appealing. If you’re going to convert someday anyway, you might as well do it when the tax bill will be a bit smaller.
Among the issues to consider:
Tax rates now and later. If you believe the government will raise income tax rates significantly, a conversion might pay off. Tax rates have been higher in the past, and some experts think they will rise again because of high government debt and other factors. But it’s anyone’s guess where rates will be when you withdraw your last dollar from a retirement plan in 20, 30 or 40 years.
Your income now and later. Even if tax rates do not change, a conversion could make sense if you think your income will be higher in retirement than it is now, lifting you to a higher tax bracket. While most people don’t expect a bigger income in retirement, it could happen if you are just starting your career now, your investments do very well, you receive an inheritance, or if you have a depressed income today because you or your spouse are out of work.
Where will the tax payment come from? If you convert, you may have to pay thousands of dollars in taxes, perhaps more. Most experts say a conversion makes sense only if the investor can avoid tapping into the converted funds to pay the tax bill. Doing so can shrink the account enough to offset the benefit of future tax savings. So the conversion tax should be paid from other assets.
Other benefits. In addition to their tax-free status, Roth IRAs, unlike traditional IRAs and both kinds of 401(k)s, are not subject to the requirement that withdrawals begin after the investor turns 70½. That means assets can be left untouched to continue to grow. A Roth IRA is also a good way to pass money to heirs, since inherited Roth accounts can be tapped tax-free.
The rules on all these accounts are complex, with lots of special circumstances and exceptions, so talk to your plan provider or financial advisor before converting or recharacterizing.
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A Roth Conversion May be the Best Prescription for an Ailing Portfolio originally appeared on usnews.com
