Our heads are spinning. The market goes up; the market goes down and then it goes down again before it goes up … and so on and so forth. Even in a fluctuating market there are individual retirement account (IRA) planning techniques that can be advantageous to consider. While the IRA area is replete with traps and pitfalls, this advisory piece may help you turn a lemon into lemonade.
If you hold a significantly depressed security in your IRA but you have no intention of selling it, you should consider transferring it (i.e., converting it) into a Roth IRA. Yes, you’ll have to pay federal and state and local income taxes on the current value of the security but if it does come back to life (i.e., increase in value), the increase, when ultimately withdrawn, will not be subject to income taxes, whereas had you left the security in your traditional IRA, it would, when ultimately withdrawn, create ordinary income on the increased market value.
Gershwin Inc. was purchased in an IRA for $25,000 but now is worth $5,000. You believe in Gershwin and don’t want to sell it. You are over 59 ½ years old (see below). You have it transferred to your Roth IRA. You’ll pay a 2016 income tax on $5,000. Years later, Gershwin increases in value to $18,000 and you sell it. Under current law, the $13,000 never will be subject to an income tax no matter when it is withdrawn from the Roth IRA. Had you left Gershwin in your traditional IRA and sold it, ultimately when distributions were made, you (or your beneficiaries) would pay an ordinary income tax.
Traditional IRA v. Roth IRA
IRAs were enacted in 1974 primarily to benefit people who did not have a company retirement plan. It was supposed to be simple. There was no need to preface ‘IRA’ with an additional description; however, when Roth IRAs (named after Senator William Roth) were enacted in 1997, an adjective was needed to distinguish the two types of IRAs; hence, the word ‘traditional’ was added to the IRAs which create ordinary income upon withdrawal.
If you are over 70 ½, you are subject to the required minimum distribution (RMD) rules if you have a traditional IRA. A conversion to a Roth IRA after you are 70 ½ won’t qualify as (i.e., won’t reduce) part or all of the RMD for that year. Another twist is that if you want to convert the Gershwin stock to your Roth IRA, you first need to withdraw the current year’s RMD before you will be allowed to trigger the conversion.
Your brokerage house has told you that your RMD for 2016 is $30,000. Usually, you are informed of the current year’s RMD along with your January statement. Before you can transfer the $5,000 of Gershwin stock to your Roth IRA, you will need to take the $30,000 out of your traditional IRA.
Undoing the Roth conversion (often called a ‘recharacterization’)
If you decided to do the conversion in 2016, but Gershwin didn’t do as well as you had hoped, you may be feeling “conversion remorse” in 2017. A beautiful thing about converting to a Roth IRA is that it can be undone up until Oct. 15 of the following year (in our example, it would be Oct. 16, 2017, for a 2016 return because Oct. 15, 2017, falls on a Sunday) even if you filed your tax return earlier. By undoing it, you eliminate the income tax on the converted amount. From a practical standpoint, if you think that you might undo the Roth conversion in 2017, you should delay having your 2016 tax return finalized and filed so as to avoid the additional professional costs associated with the need for filing an amended income tax return.
If you did a 2015 conversion, there’s still time, along the lines described above, to undo it.
Consider the effect of the above commentary, if your state has an income tax. For example, New York excludes the first $20,000 each year for a ‘qualified’ distribution. It may be beneficial to start taking distributions after reaching 59 ½ by converting the said amount each year into a Roth IRA. In effect, you will be prepaying the federal tax but permanently avoiding the state tax on each year’s $20,000. You should consider what your future federal tax rate will be if and when you expect to retire but if you expect your tax rate to remain the same as it is now, don’t give it a second thought. The benefit can be doubled if your spouse also is over 59 ½ and maintains a traditional IRA.
Additional IRA planning thoughts
So, you’ve read the above planning technique and decided that it’s not for you but what about your parent or parents? Maybe you can help them take advantage of the idea. Did someone in the family recently pass away? How about some planning for that recently inherited IRA? Or, maybe you expect 2016 to be a bad financial year or you have a net operating loss carryforward. This might be the ideal year to convert some traditional IRA funds to a Roth IRA.
Suppose you are under 59 ½ and would incur a 10 percent penalty for an early distribution. Weigh incurring the penalty at 10 percent versus leaving the funds in the traditional IRA and ultimately paying at a much higher income tax rate.
Although distributions from traditional IRAs are not subject to the 3.8 percent tax on net investment income, the distributions will increase the ‘modified’ adjusted gross income (AGI) of the taxpayer (i.e., AGI plus tax-exempt income) and may push that taxpayer over the threshold for subjecting him/her/them to the 3.8 percent additional tax. Also in the case of moderate income taxpayers (e.g., perhaps you or your senior citizen parents), it may cause the taxability of otherwise untaxable Social Security and/or, in a future year, subject the senior citizen taxpayer(s) to a higher Part B (doctors) and Part D (drugs) Medicare cost.
Before contacting your Baker Tilly advisor, you may want to do some research. Below are links to two IRS publications that may help.
Publication 590-A - Contributions to Individual Retirement Arrangements (IRAs) – For use in preparing 2015 Returns
Publication 590-B - Distributions from Individual Retirement Arrangements (IRAs) – For use in preparing 2015 Returns
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.