WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
We all know 2022 was a terrible year in the stock market...
Ultimately, however, this does not concern us.
We know the following to be true:
By every measure of history, stock market declines are temporary and their inevitable advances are permanent. Therefore, short term market volatility simply transfers wealth from those who can’t handle it to those who can.
Put another way, we do not simply own “stocks” but rather we are stakeholders in a collection of the world’s most successful businesses. And, all throughout 2022, the great companies of America and the world were being offered to us all at an incredible discount.
These two points lead us to a final fact:
The risk is not that you will get caught in a further decline of another 20%.
The risk is that you will get caught out of the next 100% advance.
In short, times like these are why we build Financial Life Plans™ for our clients.
If you have a purpose-driven Bucketed Investment Plan, your money will be intentionally positioned to achieve your long-term financial goals and short term price fluctuations will become wholly irrelevant.
Of course, these facts do not erase the pain (however temporary it may be) of seeing your investment portfolio balances plummet with each passing week. I feel that pain right along with you.
But these losses actually provide us with a fantastic opportunity to make ourselves more tax-efficient in the long run.
As Winston Churchill once said, “Never let a good crisis go to waste.”
Ok, fine, this isn’t quite as dramatic. But still we get to make lemonade out of the gigantic lemon that was investing in 2022.
Let’s discuss one such tax strategy: The Market-Driven Roth IRA Conversion
Many of you have a 401(k) or 403(b)’s through your employer. These accounts can be set up as “Traditional" Pre-Tax Accounts or "Roth" After-Tax Accounts (or some combination of both.)
The difference between these 2 accounts is simply when you’re choosing to pay taxes taxed on the money.
With a pre-tax 401k, IRA, 403b (or SEP IRA/Solo 401k if you’re self-employed) you get a tax-deduction for your contribution in the current year, as well as tax-deferred growth over time, BUT you have to pay ordinary income tax whenever you distribute the money in retirement.
Let’s not overlook this last piece.
So, if you have $1,000,000 in your 401(k) and you want to liquidate the portfolio at 62 to buy a vacation home…well you’re only actually going to net about $600k-$700k (assuming a 30% tax bracket) because every dollar that you take out is immediately taxable at ordinary income rates. And this makes sense…. you’ve never paid a dollar in taxes on the money inside of that account (not when you contributed the funds and not as it grew.)
On a Roth IRA/401k, it’s actually the opposite. Your contribution does not a result in a tax-duction in the current year, but the money will grow tax-free AND be distributed tax free in retirement. So if you have $1,000,000 inside your Roth IRA, you will actually net the full $1mm when you decide to distribute the funds…you do NOT owe the IRS any portion of your retirement account.
This is why we talk all the time with clients about the fact that the value of your money is not simply reflected by the number on your statement. $1,000,000 your Pre-Tax IRA might mean $700k in your pocket when you take the money out, whereas that same amount in your Roth IRA will actually mean $1,000,000 whenever you elect to take the money out. Our chosen tax structure makes a HUGE difference in the long run.
Now, this is not to say that we only & always want Roth Retirement accounts at the expense of saving into Pre-tax accounts…It’s absolutely not that black/white.
Ok, so to paint a balanced picture... when might you prefer Pre-Tax Retirement Accounts?
- If you are on the cusp of a lower tax bracket in the current tax year, it might make sense to feed more money into your Pre-tax retirement account in order to allow the deduction that comes with that contribution to push you into that lower bracket. (This is particularly important if we have the opportunity to go from the 32% to the 24% in any given year)
- You don’t have ANY Pre-Tax retirement accounts. The standard deduction (or itemized if that is more advantageous for you) means that the first $12,500 of ordinary income ($24,500 if married) is tax-free regardless of the source. We want to make sure that you will have at least this amount being generated for you in retirement from your Pre-Tax Acounts….as doing so will ensure that this particular pot of money is never actually taxed. Follow the thread- you didn’t pay taxes on the Traditional IRA contribution, it grew tax-deferred, and now upon distribution it fits under the standard deduction 0% tax rate.
- You think you will be in a substantially lower tax bracket in retirement. Naturally, if you’re in a higher tax bracket now than you think you will be in retirement, it’d behoove you to defer the tax payment until the moment when your tax rate drops. (As an aside: while this is theoretically possible, I think this is one of the biggest misnomers out there. If you are going to be making $400k+ for the balance of your working years, it’s HIGHLY unlikely that in retirement you will be comfortable pulling in $50k annually. You will always have $100k-$200k in income coming to you whether from part time work, consulting, distributions from retirement accounts, real estate, capital gains etc. Simply put, and from experience, your tax bracket will not be quite as low as you might think it will be in your retirement years because you’re just not going to just be able to turn a switch. What’s more likely is that once you’ve hit a certain level of income/assets/lifestyle, you will be in the 24% tax bracket just by waking up in the morning.
(And this is to say nothing of the fact that tax rates across the board will be going up over the next 20+ years. For a more complete breakdown of why this is our approaching national reality as well as to glean more detail into tax efficient planning, please see a recording of my webinar here)
Ok, looking at that list…you will realize there are SOME reasons to build Pre-Tax Retirement Accounts over their Roth counterparts but they are all pretty specific and even then, they should be done to a limited extent.
The reality is that for high earning young people, Roth Retirement Accounts are a HUGE opportunity. (I emphasize young people here because the longer time frame that you have for your money to grow tax-free before accessing it, the more valuable the Roth Strategy actually becomes).
Ok, so how do we get more money into Roth Accounts? It’s a relevant question because 99% of our clients make too much money to contribute to a Roth IRA directly (their income being above the IRS threshold to do so). Instead, we can look to build Roth accounts through:
• Backdoor Roth Contributions
• Mega backdoor Roth Contributions
• Roth IRA Conversions
We will save the first two for another time but I want to speak to the benefit of Roth Conversions today because they are especially valuable to enact when the market is in temporary decline.
By way of an intro, A Roth Conversion is when we decide to convert your Traditional IRA (which you may have as a result of a 401k rollover from a previous job or contributions you made when your income was lower and you were younger) into a Roth IRA. I think an example is the clearest way to illustrate how it works:
You have $200,000 in your IRA….and we determine together that it makes sense to convert this money into a Roth IRA. This means, logistically, that we are adding that $200,000 to your taxable income for the year. (So, yes, if you are in the 25% tax bracket, that $200k conversion will result in paying an additional $50k in taxes which we will just assume you are paying out of your bank account.)
Woah, that’s a big tax bill! So why did we do that? Because now we have $200k sitting in a Roth IRA…forever! This means that when this account grows to $800k 20 years from now (7% rate of return), you will be able to distribute the FULL $800,000 tax-free. You chose to pay $50,000 today instead of paying $200,000 in taxes when you take the money out upon distribution (estimating a 25% tax bracket in the future as well)
(This is a good time to mention that effective tax planning is not about lowering your taxes in any one year but about USING time to lower your lifetime tax liability. This also explains how tax prep/filing and tax planning are two totally different functions.)
Ok, so when are the most appropriate times to convert a Traditional IRA into a Roth?
When you will pay the least amount in taxes to do so!
This is why market timing Roth Conversions are so powerful. Let’s use that example from earlier to explain.
We are looking to convert a $200,000 Traditional IRA.
Except, because the market is off 25% year to date, that $200k IRA is actually worth $150,000 right now. So, if we were to convert your Traditional IRA right now…at its low market value, you would be adding $150,000 to your taxable income this year instead of $200k (would save you $13,500 in taxes for moving over the same exact amount of shares in the portfolio)!
Even better - when the market rebounds, as it inevitably will, you are now benefiting from the market rebound inside of a tax-free account instead of a tax-deferred account which means that the growth of that money just became intrinsically more valuable to you long term! Every dollar of growth in an account that is tax-free is worth a full dollar to you. Every dollar of growth in an account you will eventually owe 30% to Uncle Sam means that you are really only ever earning only 70% of that dollar.
If you need some help putting this all together…. book your 15 minute Right Fit Call.