Down market? It’s Roth time!
The recent chaos in the market, coupled with the most significant sell-off since 1987, has at least one silver lining: if you intend to invest you can invest in a Roth vehicle and recoup gains potentially tax-free. Roth IRAs, and their bigger sister, the Roth 401(k), provide the opportunity for savers to develop investment returns on a tax-free basis.
Let’s hypothetically say you owned the S&P 500 and suffered the indignity of about a 25% loss since February 19, 2020. Since, in our hypothetical example, you are confident that the market will recover, go tax-free. Recall investment math, if you suffer a 25% loss, you need a 33% gain to get back to even. A 33% gain would be pleasant, and a 33% tax-free gain would be more pleasant. A key rule of Roths: the time to fund a Roth is when the market is low.
Roths have some very nice features:
- Growth is tax-free for qualified distributions (generally age 59 ½ or older and with more than five years of contributions, with an exception for contributory IRAs, see below)
- Roth IRAs are not subject to Required Minimum Distributions (RMDs), so you don’t have to take distributions at age 72 (remember the changes brought on by the SECURE Act). You can accumulate without distribution until your death, and your spouse’s death.
- The new SECURE law mandates distributions to non-spouse heirs of inherited IRAs over ten years, against the much more advantageous ‘stretch’ provisions. A Roth IRA allows children of inherited IRA owners to grow the inherited Roth tax-free for ten years past the date of the death of the last spouse.
- You can still contribute for 2019 until April 15, 2020. You could, if you had funds available, make a contribution for 2019 and 2020 for you and your spouse. This would max out at $24,000 ($28,000 if you’re 50 or over).
There are two basic Roth options: contributory and conversions. In a Contributory scenario, you contribute to the Roth option on an after-tax basis. Conversions happen when you ‘convert’ another type of IRA or §401(k) into a Roth by paying the taxes. Remember, Roth conversions work best when the taxes are paid from outside sources.
Contributory options include the following:
Contributory Roth IRA.
These are a great vehicle if you make less than $196,000 of Modified Adjusted Gross Income (Married filing joint) or $124,000 (single). Contributory Roths are limited to your earned income (only one spouse needs earned income) and you can contribute $6,000 each or $7,000 if you are 50 or older. Contributory Roths have a lovely special feature called FIFO (First-in/First Out), which allows a withdrawal of contributions tax and penalty-free at any age, provided you have participated in the Roth for at least five years. The contributory Roth is an excellent vehicle for children with earned income, who are typically in a low tax bracket. If you start a Roth for the kids, don’t forget that the Savers Credit is available in some circumstances, and applies to Roths. Low market + low tax bracket (plus a possible credit) = Contributory Roth IRA.
This is for savers with more than the requisite income levels. In this scenario, you’d contribute to a nondeductible IRA and immediately convert the nondeductible IRA to a Roth. Exercise caution in doing this if you have other taxable IRA assets. You generally want exclusively nondeductible IRA assets to do a back-door Roth.
The DRAC, or Deductible Roth Account Contribution, is a way to boost tax-free savings. This is an option in most §401(k), 403(b) and some 457(b) plans. Here you can contribute $19,500, or $26,000 if you are 50 or older, on an after-tax basis. You pay the tax on your contributions, but you generate all gain and income tax-free. Always roll a Roth DRAC into a Roth IRA. For some perplexing reason, Roth 401(k)s are subject to Required Minimum Distributions, and Roth IRAs are not.
This is a special rule, enacted recently by the IRS, that allows a significant (something akin to $37,000) additional contribution to a 401(k) or other qualified plan. This is predicated on multiple caveats, like the plan must allow it, the plan has to meet contribution rules, and you have to have to have the money.
Couple all the Roth rules together and you can generate tax-free savings in multiple accounts: IRAs, DRAC, and Mega. They add up to as much as $57,000 + 6,000 = $63,000 (under 50) and $63,500 + 7,000 = $70,500 (50 or older) per spouse. That’s up to $141,000 in tax-free savings, and that’s big money.
In this situation, you’d convert a conventional IRA to a Roth by paying the tax. Roth conversion make sense when the owner is in a lower tax bracket than the recipient. This can be a retiree, who has not yet taken RMDs, or an older parent in a lower bracket, with children who will inherit part or all of the IRA. In a down market when you expect that the market will recover, is an optimum time to convert an IRA to a Roth. To convert, you pay taxes on the fair market value of the taxable portion of the IRA. So, if you have an IRA invested in XYZ stock, which is down 30% and convert to a Roth, you pay taxes on the fair value. If it recovers, you will have made the gain tax-free.
Bracket-topping is a strategy consisting of converting enough of the IRA to a Roth to take you to the edge of a tax-bracket. This works particularly well if you can offset income with things like charitable contributions, which is called a Roth charity offset.
Remember you can convert a Roth in-kind, which is merely moving the existing assets from your conventional IRA to a Roth. Do you have a stock you love which has been battered in the melee? Move it to your Roth.
Down Markets and Roths.
In a down market, you have opportunity to pay less tax on the input to the Roth options. In general, you’d like to invest Roth assets in the highest-performing assets. It makes sense to go Roth in areas where you foresee the best performance. Here’s a helpful exercise to help you create your battle plan: ‘If I had $6,000- $150,000 to invest in March of 2009, what would I buy?’ and translate that to 2020.
Warning: Wash Sale.
One thing you don’t want to do is sell a stock in your taxable account (non-IRA) and then buy it immediately in your Roth. You might think you are being clever by taking a deductible loss and growing it back tax free, but there is the ‘wash-sale’ rule, which prohibits that kinds of transaction to deduct the loss. Want to harvest losses? Buy something not ‘substantially equal’. So, if you want to deduct the loss on your S&P 500 fund, buy a total market index fund or ETF. Or, you can wait at least 30 days before or after to buy the security.
You either think the market will recover or you don’t. If you do and you have the funds, set up Roth IRAs for yourself, your kids, or your parents, stash more in your 401(k) Roth options, think about Mega-Roth or convert Roth IRAs. You’ll be happy when the market goes back up. You’ll be happier when it goes up tax-free.