I’m someone who always looks for a silver lining. In taxable accounts, we harvest portfolio losses when volatility strikes to offset gains elsewhere in the portfolio. But there’s a way to turn lemons into lemonade in tax-deferred accounts like IRAs. For example, you might consider converting a traditional IRA that has declined in value to a Roth IRA. (Remember, although there are income limitations as to who can open a Roth, anyone can convert a traditional IRA to a Roth IRA.)
And who doesn’t want a Roth IRA? After all, qualified withdrawals from your new Roth will be tax-free. Of course, what often stops investors from converting a traditional IRA to Roth IRA is that the converted amount is added to your income, so taxes are due. However, in the case of an IRA that is declined in value, you are converting a smaller amount, so the taxes will not be quite so burdensome.
Of course, not everyone with an IRA account that’s down in value should convert to a Roth IRA. Depending on the size of the conversion, the move to a Roth could increase your taxable income to the point where you get bumped into a higher federal income tax bracket. Also, if you expect that your taxable income in retirement will be significantly lower than it is now, the potential value of a Roth IRA’s tax-free distributions would be reduced. Also, keep in mind that you need to have enough cash on hand to pay the conversion taxes! These are all excellent scenarios to explore with your trusted advisor.
Also, there’s one additional consideration. Given the extreme market volatility we are experiencing – the S&P is down 8% to start the year!—you might worry about what will happen if you convert your IRA and pay the taxes due on the conversion, and your IRA account continues to decline. That is, if your $50,000 account falls to $45,000 over the course of the next few months, you may find yourself wishing that you waited to convert so your conversion tax bill would be even lower. But fear not. The IRS permits a process of reversing a Roth IRA conversion that is known as a “recharacterization.” This process needs to be completed by the last date, including extensions, for filing your prior-year tax return, which is typically on or about October 15. Recharacterize your new Roth IRA back to a traditional IRA and it’s as if the conversion never occurred. More amazing still, if you later decide that you want to convert your recharacterized traditional IRA back to a Roth IRA, you can do that either in the next tax year after the conversion or 30 days after the recharacterization, whichever is later.
To facilitate any future recharacterization of your Roth conversion, it’s wise to open a new Roth IRA rather than investing the converted funds in an existing Roth account. In a new Roth account, it will be obvious that any future losses are related to the conversion.
Also, keep in mind that you don’t have to convert your entire traditional IRA to a Roth IRA. You can convert any percentage you want, but remain mindful not to convert so much that you find yourself in a higher tax bracket. What’s more, you can invest your funds in multiple Roth IRA accounts. Some investors spread the converted funds among various asset classes with the idea that they will recharacterize any account that falls in value.
Again, your trusted advisor can help you formulate a Roth conversion strategy that works for you based on an analysis of your tax rate now versus your future tax rate, as well as the outlook for the market.
