Opinion: How to build tax-free wealth in down markets

Long-term investors could benefit from the stock market pullback and changes to the tax code to build significant tax-free wealth. Adding to a Roth individual retirement account in a down market could amplify tax-free accumulation when the market recovers. With lower tax rates for most Americans under tax reform, the tax savings on Roth conversions could minimize the tax barrier to growth. Investors need to be aware of the most recent changes and opportunities.

The Tax Cuts and Jobs Act of 2017 revamped the tax code. Among other items, the act lowered personal income tax brackets and broadened the amount of income taxed in those lower brackets. As a trade-off for a high standard deduction, the law limits some itemized deductions, which could result in higher tax bills for some. The current rates are scheduled to sunset in 2025. Therefore, Americans could be paying higher taxes in future years. Investors should take advantage of the tax window.

There are three ways to fund a Roth IRA.

1. Make a direct contribution. Individuals are allowed to contribute 100 percent of earned income up to a maximum of $6,000 per year. Taxpayers over age 50 can contribute an additional $1,000. The adjusted gross income phase-out range for single filers is $122,000-$137,000. The phase-out range for married filing jointly taxpayers is $193,000-$203,000. Income in excess of the upper limits renders the taxpayer ineligible for direct contributions.

2. Convert all or part of a traditional IRA to a Roth. Although income tax is due on the Roth conversion, investors may benefit from intentionally triggering tax at these lower post-tax reform rates. The IRS limits contributions to Roth IRAs, but there are no limits on conversions. For individuals who pay little-to-no income tax, Roth conversions merit consideration.

3. Through a backdoor Roth contribution. This strategy is an important planning tool for higher income taxpayers. It allows taxpayers with income in excess of Roth AGI thresholds to make a nondeductible contribution to a traditional IRA and then convert the funds to a Roth. Because no tax deduction is received for the contribution, no taxes will be due on the conversion provided certain rules are followed. After-tax contributions should be tracked on IRS Form 8606. Although an investor must have earned income and be younger than 70 and a half, there are no AGI limitations for contributing to a traditional IRA. If the taxpayer is considered an active participant in an employer retirement plan, varying AGI thresholds determine deductibility. Backdoor Roth contributions require due diligence.

The step doctrine collapses multiple transactions into a single transaction to determine if the end result was lawfully obtained. For example, a contribution to a nondeductible IRA followed by an immediate Roth conversion would be viewed as a direct Roth contribution. The workaround has been to allow time to pass between the traditional IRA contribution and conversion.

However, footnotes 268 and 269 of the Tax Cuts and Jobs Act Conference Report may have nullified the step doctrine as it pertains to the backdoor Roth strategy. Footnote 269 states, “Although an individual with AGI exceeding certain limits is not permitted to make a contribution directly to a Roth IRA, the individual can make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA.” Consult with a tax professional for their interpretation.

Beware of the aggregation and pro rata rules when traditional IRAs hold both deductible and nondeductible contributions. Let’s assume a high-wage earner active in a 401(k) plan has $95,000 in a traditional IRA. This investor decides to make a $5,000 nondeductible backdoor Roth contribution, which increases the IRA aggregate balance to $100,000 (95 percent pretax and 5 percent after tax). Because distributions are subject to the “pro rata rule,” only 5 percent, or $250, of the $5,000 conversion would be tax free. The investor would owe tax on $4,750.

The Tax Cuts and Jobs Act repealed the do-over strategy referred to as “recharacterization.” This would have allowed the investor to reverse the transaction. However, the investor could transfer the $95,000 pretax balance to their 401(k) if the plan allowed. Since there would then be no other pretax IRA money, the $5,000 nondeductible contribution would not be taxed upon conversion.

Roth IRAs are distributed in this order: regular contributions, conversions and rollover contributions, then earnings. Investors can access Roth IRA earnings without penalty after five years or attaining age 59 and a half, whichever is longer. If an investor has a Roth 401(k) and/or after-tax contributions to rollover to a Roth IRA, the five-year holding period must be met before distributions are considered tax-free. To prepare for retirement, investors should establish a small Roth IRA to start the five-year clock ahead of rolling over the Roth 401(k).

Andy Drennen, certified financial planner, is a vice president and portfolio manager at Central Trust Co. He can be reached at andy.drennen@centraltrust.net.