April 08, 2020
This is the second in a six-part series that focuses on proactive planning strategies in a volatile market.
Do you have a traditional IRA that will produce ordinary income on distributions? Would you like to possibly mitigate income taxes on those distributions for yourself as well as your heirs?
Financial markets have declined over recent weeks, as investors digested evidence of a steep downturn among the world’s largest economies. The COVID-19 crisis is not a market-based problem, but markets are reacting with volatility as unknowns worry investors worldwide.
There may be a silver lining for retirement savings and wealth planning. The current market downturn is an opportunity to potentially save on income taxes and generate income tax-free growth for retirement savings as markets recover. This could be accomplished through a Roth IRA conversion.
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Tax-free contribution accounts like traditional IRAs, 401(k)s, and 403(b)s are the most-common type of retirement account and are funded with pre-tax dollars. They grow tax-free but are taxed at withdrawal as ordinary income.
Tax-free withdrawal accounts like Roth IRAs and Roth 401(k)s, on the other hand, are funded with after-tax dollars. Tax is paid before contributing the funds, so they grow tax-free and allow income tax-free withdrawals.
Alternatively, existing traditional IRA can be converted to a Roth IRA by pre-paying the income tax on the withdrawals currently. This prepayment of income tax will allow the assets in the IRA to grow tax-free thereafter, and allow income tax-free withdrawals (as long as the funds are not withdrawn within five years of the conversion to a Roth IRA). For those who wish to retain the value of the tax-free Roth account, it is more advantegous to pay the tax with funds outside of the IRA. Note that a conversion and payment of tax does not need to apply to an entire existing IRA. Partial conversions are permitted.
Converting retirement savings from a traditional IRA to a Roth IRA now, while portfolio values are lower than they were earlier in the year, should result in a lower income tax liability. After the conversion to a Roth account, any growth generated as the market recovers will not be taxed as ordinary income when the funds are withdrawn from the Roth IRA, subject to the five-year period mentioned above.
Another potential benefit of Roth IRAs is that, unlike traditional IRAs, they are not subject to required minimum distribution (RMD) rules while the owner is alive. The assets in a Roth IRA can remain in that Roth IRA for life. If those assets are not used for the owner’s retirement, they can be passed as tax preferred assets to the account owner’s heirs (note that there are separate rules pertaining to inherited Roth IRAs). This can be a tremendous tax benefit for overall family wealth planning.
Even a distressing downturn like this one creates opportunities for long-term investors and for generating wealth that can help taxpayers and future generations. Take advantage of the opportunities this moment affords to find a silver lining for retirement dollars.
Learn more about The Financial Side of Retirement Planning.
Proactive Planning During a Time of Uncertainty and Volatility
Part 1: Proactive Planning in Volatile Markets With Grantor Retained Annuity Trusts (GRATs)
Part 3: Proactive planning with low market values using Spousal Lifetime Access Trusts
Part 4: Proactive planning with low market values using a sale to a Grantor Trust
Part 5: Proactive planning with low interest rates using intra-family loan
Part 6: Proactive planning with low market values using gifts
March 22, 2020
March 26, 2020
April 13, 2020
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