This May Be the Best Time in Your Life to Become Tax-Free and to Diversify Your Assets

A Roth IRA is an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. Roth IRA rules dictate that as long as you've owned your account for 5 years and you're age 59? or older, you can withdraw your money when you want to and you won't owe any federal taxes.

The Tax Sale of a Lifetime

The coronavirus downturn in the market is actually the perfect time to do a Roth Conversion because of the double sale that’s going on.  

The first sale involves the next six years where - due to the TCJA- we get to enjoy the lowest tax rates we are likely to see in our lifetimes. The second sale is due to the 35% drop in the stock market your assets are now at much lower values and that means the tax on a potential Roth Conversion is also 35% lower.

If you were to hypothetically convert a $1 million IRA this year, your tax bill would be approximately $299,112 or a 29% effective tax rate. If you take in the decline in the stock market of 35%, your tax bill is a little more than half.  You forego giving the IRS some $140,000. (This is an example. I’m by no means suggesting to do it all this year).

If the stock market goes through a massive recovery over the next few years, having done this Roth Conversion, all of that recovery occurs in your tax-free bucket.

If the market is down 25%, your portfolio has to recover 33% to get back to where you started. If the market drops 50%, you need a 100% recovery to get back to even. Where would you prefer to have that recovery occur, in your tax-deferred or your tax-free bucket?

You have the opportunity to take advantage of a double tax sale right now. Your assets are 35% lower than they were about a month ago and that means the cost of getting into the tax-free bucket is on sale right now as well.

No matter your age, the very best place to pay for the taxes of a Roth Conversion is out of your taxable bucket. If you have more than six months worth of expenses in your taxable bucket you have some inherent tax inefficiencies in your portfolio that can cost you hundreds of thousands of dollars over your lifetime. Let’s use our least efficient bucket to help move money into our most efficient bucket.

What about creating a Private Reserve Account?

With the tremendous volatility and continuing unknowns in the market, many people wish to sidestep the risk completely. A properly constructed permanent life insurance policy (aka PRA-or LIRP) is a unique vehicle to diversify your assets out of the market, capturing market growth while minimizing market risk. When designed properly, it offers a number of surprising benefits:

?       No contribution limits

?       No income limits

?       No legislative risk:  subject to contract law; not vagaries of tax law

?       Tax-free growth

?       Tax-free withdrawals – not limited as to age

?       Low interest loans with no questions asked

?       Liquidity, use, and control of the cash

?       No losses.

All this with excellent growth potential: Indexed TO the market, but NO market risk.

In fact, these accounts have beaten the market return for 20 years. 

Few people are aware of the benefits of these tools, and even fewer advisors are capable of setting them up properly. So look carefully. Now, these are insurance products; therefore they require qualification, and not everyone will be able to get them. 

Questions and Options to Consider

Thinking conversion may be the right move? Ask yourself three questions. First, when will the money be needed? If you need your IRA money immediately for living expenses, converting may not be for you. Second, what is your tax rate? If your income is lower, that may favor conversion. Third, do you have the money to pay the tax on the conversion? As mentioned, it is best to pay the conversion tax from non-IRA funds.

Not sure about converting? The good news is that conversion is not an all-or-nothing decision. You can always hedge your bets and do a partial conversion of your traditional IRA during this low tax window. 

Many people have a 60/40 bond/stock portfolio.  What about pulling out of the bonds, which actually may be up at this time, but are subject to risk of the upcoming inflationary environment? You can’t just print anywhere from $4 trillion to $7 trillion in new money and not expect that it won’t damage the value of your buying power. (remember bond prices drop as interest rates rise).  

Or, you can move only a portion into a PRA. Or consider a mix of PRA and Roth.  

Is Conversion Right for You?

Should everybody convert? No, of course not. Conversion is not one size fits all. Also, remember that Roth conversions are now irrevocable. There is no more recharacterization or the ability to undo a conversion. This means you must be very sure before you go ahead with the transaction. Are you a good candidate? Is now the time for your conversion? Professional advice is more valuable than ever. The best way to find out what is right for you is to discuss conversion options with a knowledgeable financial advisor…one who will look at all the possibilities; not only those that are market-based. Look for one who understands not only the PRA, but also how to minimize taxes and fees – now, and in the future. 

If you want to get into the zero percent tax bracket, you have a huge opportunity right now. The market will likely recover at some point in the future, and that means there are a number of great deals to be had right now. Ideally, your assets will be able to recover in the tax-free bucket and there is a big opportunity to do so in this market downturn.

*not specific personal investment, tax or legal advice. Consult your tax and legal professionals for your situation.