Keeping a focus on the bright side may not have been easy in recent months, given the market’s tumultuous start this year.
But in ensuring that clients are grounded and have their eyes on the long term, it is smart to plan to take advantage of some silver linings amid the market volatility.
First and foremost, in taxable accounts, a good strategy is to harvest portfolio losses when volatility strikes, in order to offset gains elsewhere in the portfolio. Many investors wait until year-end to harvest losses, much in the same way that they hastily clean out their closets over the holidays to claim a charitable deduction for the year.
Harvesting throughout the year in response to market declines can maximize the value of this strategy, however. And, quite frankly, when advisers harvest losses and then invest the sale proceeds in a similar but not identical securities per the Internal Revenue Service’s wash sale rule, they often satisfy clients’ desire to do something in response to the market, all without altering their asset allocation and while booking valuable losses.
TURNING LEMONS INTO LEMONADE
There is also a way to turn lemons into lemonade in tax-deferred accounts, such as individual retirement accounts. What’s more, talking about retirement plans with clients certainly helps keep them squarely focused on the long term.
During the recent market decline, some of my clients converted traditional IRAs to Roths. Remember, there are income limitations as to who can open a Roth, but anyone can convert a traditional IRA to a Roth IRA.
And many clients might want a Roth. After all, qualified Roth withdrawals will be tax-free.
In addition, because Roth withdrawals don’t count as modified adjusted gross income, they don’t affect a client’s tax thresholds for the 3.8% Medicare surtax or Social Security income taxation. And there are no required minimum distributions.
That provides some real planning flexibility, something that can be of particular benefit in extreme markets.
Yet clients often balk at converting a traditional IRA into a Roth because the converted amount is added to their income. So taxes are due.
Here is where the volatile market helps: When an IRA declines in value, the conversion taxes won’t be quite so burdensome. And once in a Roth account, all future appreciation on those converted assets is tax-free.
To be clear, not everyone with a traditional IRA account that is down in value should convert to a Roth. Depending on the size of the conversion, the move to a Roth could increase a client’s taxable income to the point where he or she is bumped into a higher federal income tax bracket.
Also, for advisers who expect that a client’s taxable income during retirement will be significantly lower than it is now, the potential future value of a Roth’s tax-free distributions would be reduced or even negated. And, again, the client needs to have enough cash on hand to pay the conversion taxes.
When presenting this conversion strategy to clients, keep in mind that, given the market’s extreme volatility, they might worry about converting their traditional IRA to a Roth, only to see the value of the new Roth account decline. That is, if their $50,000 new Roth account falls to $45,000 over the course of the next few months, they may find themselves wishing that they had waited to convert so that their conversion tax bill would be even lower.
THE REVERSAL
But fear not. The Internal Revenue Service permits investors to reverse a Roth IRA conversion with a recharacterization.
This process must be completed by the last date, including extensions, for filing the prior-year tax return, which is typically on or around Oct. 15.
When recharacterizing the new Roth IRA back to a traditional IRA, it is as if the conversion never occurred. More amazing still, if one later decides to convert the recharacterized traditional IRA back to a Roth, it can be done either in the next tax year after the conversion or 30 days after the recharacterization, whichever is later.
Another strategy used to manage Roth conversion concerns is investing in multiple new Roth accounts. Often, we choose to spread the converted funds among various asset classes, with the idea that we will recharacterize any account that falls in value.
To facilitate any future recharacterization of a Roth account, it is wise to open a new Roth rather than investing the converted funds in an existing Roth account. In a new Roth, any future losses will be easier to track.
Also, keep in mind that one doesn’t have to convert the entire traditional IRA to a Roth; clients can convert any percentage they want.
Advisers, however, should remain mindful not to convert so much that the clients find themselves in a higher tax bracket. Doing partial conversions over a period of years is a useful strategy to employ to make the overall Roth conversion tax bill more manageable.
The bottom line with these conversions is that the market and tax laws can both be unpredictable. Our job is to attempt to respond to volatility with strategies that benefit clients and to plan and manage taxes in a way that affords them the most future flexibility.
For example, we suggest opening a nondeductible IRA to our higher-income clients who still bristle at the 3.8% surtax on passive income in taxable investment accounts. Although future tax-deferred growth was once the only advantage to opening a nondeductible IRA, now those IRA assets also can be sheltered from the 3.8% Medicare surtax in that tax-deferred account.
The IRA contribution limit is just $5,500 for anyone under 50 and $6,500 for anyone over 50, but every little bit helps when it comes to avoiding the 3.8% surtax. Advisers may even consider a backdoor Roth conversion of these nondeductible traditional IRAs.
This is a way for investors who earn too much to open a Roth by opening a traditional IRA first.
APPROACH WITH CAUTION
Approach this strategy with some caution. Again, we are talking about relatively small amounts.
So the same strategy of opening a nondeductible traditional IRA and converting to a Roth would have to be done every year to have a significant impact. And doing this back to back, year after year, could certainly attract the attention of the IRS.
In fact, the president’s latest budget offers some additional insight into how Washington views the backdoor Roth. No surprise, it is listed to be eliminated.
Of course, given that this is an election year and there seems to be perpetual gridlock in Washington, it is unlikely that the backdoor Roth will be eliminated this year.
Still, it is important that advisers keep their eyes on how Washington views financial planning loopholes.
This story is part of a 30-30 series on ways to build a better portfolio. It was originally published on March 30.
