Don’t Miss Tax Opportunities in Roth IRAs

Learn what you can do to maximize Roth IRA tax opportunities.

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One of the most important aspects of retirement planning that often goes ignored is the structure of investment accounts. Investors are often so focused on saving and maintaining account balances that tax opportunities for changing the nature of the accounts they hold can be missed. According to Pew Research Center, nearly 10,000 baby boomers will turn 65 each day for the next 16 years. During years where there are changes in income due to retirement or an intermission in a career, there are often planning opportunities that go missed.

Robert Schmansky
Robert Schmansky

One possibility for people close to retirement could be taking withdrawals from pre-tax accounts and paying taxes at a lower bracket today. Another option if you do not need the money today is to convert money to a Roth IRA, where you’ll (hopefully) pay taxes now at a lower average rate than you will in the future.

An individuals prepares to sign their tax forms for the year.

A quick example: Mike and Susan have typically fit into the 28 percent federal tax bracket during their working years. Due to Susan’s retirement in late 2012, and a substantial state tax deduction for taxes paid in 2013 for their 2012 state tax filing, Mike and Susan expect to be in the 15 percent bracket for 2013, before retirement withdrawals and pensions move them back into the 25 percent bracket in the future. They are currently living on money received from Susan’s severance and have no need to make IRA withdrawals. Converting to a Roth IRA and paying tax at 15 percent would make the converted amount and all future growth tax-free.

Still, a successful Roth conversion takes some planning to maximize its chances of working in this way.

While it is great to pack as much money as possible into tax-free accounts during years when you’re in a low tax bracket, one problem that arises is that your investments may fall in value after you convert. In the above example, consider if Susan converted $30,000 of her rollover IRA to a Roth IRA, and six months later, that account fell in value to $15,000. Susan would owe taxes on $30,000 for an account that is now worth much less.

One solution to the problem is to combine the strategy of converting with that of “unconverting” (in IRS language, this is known as “recharacterizing”). Investors are allowed to roll back a planned conversion before the tax filing date (including extensions, so you can recharacterize until Oct. 15 if you extend your return), and the transaction is treated as though it never happened. Recharacterization helps from the standpoint of not paying taxes on a conversion value that has declined. But it doesn’t address the loss of the tax opportunity to withdraw money from an IRA at a lower tax rate.

A possible solution to both problems is to over-convert by converting the full amount you intend to end with in both volatile assets (like stocks) and more stable assets (safer bonds and CDs), and recharacterize the accounts that ended with the lower value. In this case, let’s say Susan had intended to pay taxes on $30,000 of a conversion to optimize her tax bracket. She would convert $60,000, or $30,000 of stocks or stock mutual funds and ETFs, and $30,000 of bonds or CDs. If stocks rose in the interim before she had to file her taxes, she would recharacterize the bond account; and if stocks fell and her bonds held their value, she could recharacterize the stock account.

As long as she recharacterized one of the accounts, she would only owe tax on $30,000 of value.

Here are a few items to watch out for:

  • This strategy only works on an account-by-account basis. So you would want to set up separate conversion accounts for each asset (one for stocks, one for bonds), and recharacterize the account that was underperforming.
  • Recharacterization requires a 30-day period before converting again for the next year.
  • You will likely want to extend your tax return to make sure there is not a change in the winner or loser from April to October.
  • Of course, nothing will stop the market from doing what it will after Oct. 15; you may yet have a decline in your accounts that at that point is too late to do anything about. However, over long periods of time, we should expect stocks to grow in value, and since each conversion requires that we stay put in the Roth for five years (or until age 59 1/2 if later), it’s a good long-term bet to convert.

    Where we benefit from recharacterization is simply in avoiding short-term decline by packing as much into our tax bill as possible. In a down market, the over-converting strategy may pay off more by allowing an investor to buy more shares of stocks and stock funds. For example, for our mutual fund that declined in price by half, we can now buy twice as many shares with the safe money we converted, taking full advantage of the tax benefits of converting.

    With increasing cuts and limitations on exemptions and deductions, Roth assets are becoming more attractive. By planning for withdrawals including conversion planning, investors can lock in tax-free assets in low-income years.

    Robert Schmansky is an independent financial advisor and founder of Clear Financial Advisors in Livonia, Mich.. Rob has over a decade of experience in retirement planning and investment strategies.