Financial advisors can help investors weather market volatility with careful tax strategies.
Converting individual retirement accounts to Roths is a simple move that can offer potentially significant long-term tax savings.
“If you’re willing to consider a Roth conversion, a pretty good time to do it is when the stock market is down,” says Stewart H. Welch III, founder and managing member of The Welch Group LLC in Birmingham, Ala.
“If you had $10,000 in your IRA, and it’s now worth $8,000 and you do a Roth conversion, instead of reporting $10,000, you’re only reporting $8,000 as income,” he says. “Then, when the market recovers and the IRA starts heading back up, it’s never going to be subject to tax.”
Advisors need to look at a variety of factors in clients’ financial profiles to determine whether a conversion makes sense.
“We like to do it in a year where perhaps not just the IRA is depressed, but the income reported on the tax return is depressed as well,” says Jeffrey M. Mutnik, a certified public accountant and the director of taxation and financial services at Berkowitz Pollack Brant in Miami. “Or for an independent contractor in a down year, it may be helpful to take the IRA income to absorb other losses -- or someone may have excessive itemized deductions that don’t create operating losses and are not useful in any other year.”
Unlike tax loss harvestings, Roth conversions involve no buying or selling of assets, so there are no Internal Revenue Service “wash sale” timing restrictions on trades. Also, there is no IRS annual ceiling on how much an investor can convert.
But in a volatile market, maybe the most important plus for Roth conversions is their flexibility.
Under the right circumstances, a Roth conversion can be a good tax move for clients scared of making wrong decisions amid uncertainty, Welch says.
The IRS will let investors “re-characterize” Roth conversions through most of the year after the account was initially converted.
“Re-characterization allows you to reverse the transaction and kick the money back to your IRA. Most people won’t people won’t think of that, and a lot of people will love you for it,” Welch says.
For example, if a $10,000 portfolio converted to a Roth one year dropped in value to $8,000 the next year, the IRA’s owner would have paid taxes on the full $10,000, paying taxes on the $2,000 lost after the conversion. But the IRS allows reconversions until Oct. 15 of the year after the original conversion was made.
“The government will let you re-characterize it as if you didn’t do it and let you roll it back into the IRA, and you get the retrieval of the money you paid in income tax” Welch says.
This gift from the IRS allows investors to convert at another time.
“This second look is good through most of the next tax year,” Welch says.
Paul Hechinger is a New York-based freelance writer.
This story is part of a 30-day series on tax planning strategies.
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