As my clients and those of you who have read my MarketWatch RetireMentors articles and Retirement Visions blog posts know, I’m a huge fan of Roth IRA conversions. One caveat: they must be timely. There are two types of timely Roth IRA conversions:
Strategic Roth IRA Conversion
The goal of a strategic Roth IRA conversion is to discover opportunities that will allow you to do a conversion while minimizing income tax liability associated with the conversion. This requires preparation of a detailed income tax projection comparing income tax liability with and without a conversion of varying amounts.
Roth IRA conversions create taxable income to the extent that the value of the traditional IRA being converted exceeds its cost basis. Nondeductible IRA contributions create cost basis. Just because a Roth IRA conversion will result in taxable income doesn’t mean that you will incur additional tax liability by doing the conversion. It depends on your tax situation.
As an example, suppose you sell a rental property with suspended losses of $110,000 and a long-term capital gain of $60,000, you have other income totaling $70,000, and itemized deductions totaling $40,000. Assuming that you’re married with no dependents, your taxable income will be -$28,000 and you will incur no income tax liability.
Let’s suppose that you do a Roth IRA conversion of $100,000. Although this will increase your taxable income to $72,000, your federal income tax liability will be less than $1,000 due to the favorable tax rate on your rental property capital gain. This is an example of a strategic Roth IRA conversion since you’re recognizing additional income of $100,000 from the conversion while incurring minimal income tax liability.
Multi-year strategic partial Roth IRA conversions are also possible. I have some retired clients who take withdrawals from nonretirement investment accounts to meet their living needs. They also have other sources of income such as Social Security, a modest pension, or a fixed income annuity and a fair amount of itemized deductions.
Due to the fact that the withdrawals from these clients’ nonretirement accounts often generates capital gains, most of which are long-term resulting in favorable tax treatment, their federal income tax liability is generally negligible. This creates an opportunity to do a Roth IRA conversion with minimal tax liability.
Once again, income tax planning is the key to determining an optimal conversion amount. Since these clients are retired and their tax situations are relatively stable, strategic partial Roth IRA conversions are a possibility each year that they continue to have traditional IRA accounts or retirement plans that can be rolled over into a traditional IRA.
Market-Sensitive Roth IRA Conversion
With any Roth IRA conversion, 100% of the appreciation of the conversion amount that’s transferred into a Roth IRA account permanently escapes income taxation. Given this reality, the optimal time to do a Roth IRA conversion is following a sizable decline in the stock market. This is a market-sensitive conversion.
An important distinction needs to be kept in mind. A market-sensitive conversion doesn’t involve market timing. Market timing is a strategy whereby you make buy or sell decisions by attempting to predict future market price movements. This is very difficult to do and can backfire on you if your prediction is off the mark.
A market-sensitive strategy is more straightforward. Unlike market timing where prediction of future market price movements is the objective, a market-sensitive strategy simply looks in the rear-view mirror. If there has been a sizable drop in stock prices, say 15%, that could be an opportunity to do a Roth IRA conversion. Obviously, a 50% decline such as the one that we experienced between September, 2007 and March, 2009 would have been ideal for doing a Roth IRA conversion.
How much of a market-sensitive Roth IRA conversion you should do depends upon the value of your traditional IRA and the percentage decrease. Partial Roth IRA conversions are generally preferable, especially if the value of your traditional IRA is significant and the stock market decline is 20% or less.
I haven’t recommended a market-sensitive Roth IRA conversion to any clients since the first quarter of 2016 when the Dow lost 5% in the first two months of the year. It has since increased by 27%, making the current environment unfavorable for doing a market-sensitive Roth IRA conversion.
Mark Twain’s saying, “If you don’t like the weather in New England now, just wait a few minutes” needs to be kept in mind when waiting for an opportunity to do a market-sensitive Roth IRA conversion. The stock market, with its 220% increase since March, 2009, is ripe for a sizable correction.
Optimize Lifetime After-Tax Distributions
Whether you do a strategic or market-sensitive Roth IRA conversion, the primary objective should always be to optimize lifetime after-tax distributions. Lifetime in this context refers to the life of all investment accounts since they often extend beyond the lives of the original owners.
Strategic and market-sensitive Roth IRA conversions can both increase lifetime after-tax distributions in five ways:
- Elimination of income tax on appreciation of Roth IRA accounts
- Reduction of required minimum distributions (RMDs) and associated income tax liability to the extent that funds have been transferred from qualified retirement plans and traditional IRA accounts to Roth IRA accounts
- Potential reduction of income tax liability through increased allowable itemized deductions resulting from a reduction of adjusted gross income
- Potential reduction of taxable Social Security benefits as a result of reduced RMDs subject to amount of other income
- Potential reduction of Medicare Part B premiums as a result of reduced modified adjusted gross income
Don’t be afraid to pay some income tax from nonretirement funds in order to achieve this objective. The amount that you pay at the time of a Roth IRA conversion is often a fraction of what is ultimately paid on distributions that are taken from qualified retirement plans and traditional IRA accounts without any Roth IRA conversions.
While the ability to do market-sensitive conversions is dependent upon the performance of the stock market, strategic Roth IRA conversions are always in vogue. Any time that you can do a Roth IRA conversion with minimal income tax liability is worth pursuing. To the extent that your strategic Roth IRA conversion is also market-sensitive, it’s a home run.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.