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Leveraging a Roth IRA in the Midst of a Market Drawdown

S Rossi 2014
Stephen A. Rossi, MBA, CFA®, CFP®
Senior Vice President, Senior Equity Strategist
[email protected]
(585) 419-0670 x50677

Published on April 30, 2020 in the Rochester Business Journal

As of April 26, 2020, the Dow Jones Industrial Average was down approximately 20% from its February 12th all-time high - a significant recovery, after being down more than 38% from its all-time high on March 23rd. In the midst of this market decline - the fastest in history - now may be the perfect time to fund a Roth IRA and/or take advantage of a Roth IRA conversion. Establishing or adding to this type of account could help maximize wealth and add flexibility to one’s retirement, tax, and long-term estate plan.

Roth IRAs were first introduced as part of the Taxpayer Relief Act of 1997. This year, individuals with earned income up to $139,000 for single filers, or $206,000 for joint married filers (phase-outs beginning at $124,000 and $196,000, respectively), can contribute as much as $6,000 to a Roth IRA, or up to $7,000 for those who have earned income AND are age 50 or older.

Logistically, you make after-tax contributions to a Roth, where your money can be invested and grow on a tax-free basis. In the future, the money can then be withdrawn tax-free, subject to certain restrictions. The mechanics of a Roth IRA are very different from those of a Traditional IRA, where one would generally contribute pre-tax dollars, enjoy tax-deferred growth (not tax-free), and pay tax on the withdrawals, beginning in the year the Traditional IRA owner turned 72 (70 ½ under the old rules). At that time, Required Minimum Distributions (RMDs) from a Traditional IRA would commence, and the owner would take forced withdrawals each year, based on his or her attained age. Roth IRAs aren’t subject to these forced withdrawals (with the exception of Inherited Roth IRAs), and Roth IRA conversions can allow for much higher contributions to these types of accounts. Roth conversions accomplish this by recharacterizing Traditional IRA savings into Roth IRA savings, and forcing the IRA owner to pay tax on the amount of money being transferred/converted from one type of IRA to the other.

Historically, Traditional IRAs were recommended to those who expected to be in a lower marginal tax bracket over the course of their retirement. The idea was to contribute pre-tax dollars to a traditional IRA account and avoid paying tax at a higher marginal rate now, in exchange for taking withdrawals and paying tax at a lower marginal rate at some point in the future. Similarly, Roth IRAs were recommended to those who expected to be in a higher marginal tax bracket in retirement. Here, the investor would pay tax on their Roth IRA contributions at a lower marginal rate now, in exchange for tax-free withdrawals in the future, when he or she would’ve been subject to a higher marginal rate. The problem with choosing one type of IRA or another in this “all or none” scenario is that life tends to be dynamic, such that no one really knows what their tax situation will look like in any particular year. Proper planning, therefore, lends itself to having both types of IRAs in one’s retirement savings repertoire.

Since Roth IRAs are much newer than Traditional IRAs, it’s reasonable to assume that there’s more room to add to the former, in the interest of creating a balance between the two. Let’s also consider that individual tax rates are relatively low on a historical basis, and that the recently enacted CARES Act allows individuals older than 70 ½ to forego their scheduled RMDs from Traditional IRA retirement accounts this year. Most older individuals probably anticipated taking their RMDs in 2020, and for those who don’t require them to support their lifestyle, converting the amount of their RMD to a Roth IRA really doesn’t create any additional tax liability, versus what they were expecting to pay in taxes before the CARES Act was passed. For many, overall tax liabilities may, in fact, be less this year, simply because capital losses seem more likely to be realized than capital gains, in the wake of the current COVID crisis.

In the environment described above, it would seem prudent to add to a Roth IRA, or consider funding one for the first time. Sure, you’d have to pay tax on your contributions or conversions, but we just pointed out that tax rates are relatively low, and that many people would have paid tax on forced RMDs from their Traditional IRA accounts this year anyway. Due to the recent market drawdown, and assuming one had a constant dollar amount in mind to contribute or convert to a Roth, it’s also true that you can convert far more shares today, than you could have on February 12th (when the market was at its peak), for exactly the same tax consequence. Furthermore, contributed retirement assets, when leveraged in a Roth IRA, could result in a significantly higher balance of tax-free money available for withdrawal at some point in the future AND, by converting Traditional IRA dollars to Roth IRA dollars, one could reduce the amount of money subject to forced taxable RMDs down the road, assuming Traditional IRA account balances remain constant.

Funding a new Roth IRA, or making contributions to an existing Roth account can provide you with the flexibility of being able to draw more from taxable retirement accounts (i.e. Traditional IRAs) when annual income is projected to be low, and more from non-taxable retirement accounts (i.e. Roth IRAs) when annual income is projected to be high. As a result, you’ll have more control over your year-to-year tax liability. In the current market environment, and in an effort to more effectively leverage your retirement assets, utilizing a Roth contribution/conversion strategy like this may be an effective way to make a bad situation better, and enhance your overall financial well-being.

To see his column in the RBJ, click here.


This material is provided for general information purposes only. Past performance is not indicative of future investment results. Any investment involves potential risk, including potential loss of capital. Before making any investment decision, please consult your legal, tax and financial advisors. Non-deposit investment products are not bank deposits and are not insured or guaranteed by Canandaigua National Bank & Trust or its affiliates, or any federal or state government or agency and are subject to investment risks, including possible loss of principal amount invested.

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