This article is part of Fortune‘s quarterly investment guide for Q2 2020.
Courtney Knoll, an associate professor of accounting at UNC–Chapel Hill’s Kenan-Flagler Business School and associate director of the UNC tax center, likes to boast about an unusual number.
“I have a zero balance in my traditional IRA,” she says with a smile.
That may sound strange coming from a professor with a Ph.D. in accounting, but there’s a method to her madness. Years ago she took advantage of a somewhat obscure provision called a “backdoor conversion.” It’s a perfectly legal strategy that allows people whose income is too high to allow them to contribute directly to a Roth IRA to donate to a regular IRA, then every year “convert” that donation and move it into a Roth IRA. And, says Knoll, if you have a traditional IRA and have never done a conversion, a bear market is one of the best times to take advantage of this arrangement because values are lower, so your tax bill will be too.
Ed Slott, an IRA specialist and CPA in Rockville Centre, N.Y., agrees. His take? “People don’t like the name. It sounds like you’re up to something,” he jokes. But in reality, for the subset of investors who can afford it, a conversion right now is “a smart move.” Tax rates are so historically low (and, in his view, bound to go up given the recently passed stimulus package) that “those days of taking an IRA deduction aren’t worth it anymore,” he says, referring to a traditional IRA, in which your contributions (subject to certain limits) are tax deductible. “Everyone should be looking at converting [to a Roth] given the low values and the low tax rates.”
One added bonus: Given the Treasury Department extension, you now have until July 15, 2020, to make an IRA contribution for 2019.
First, the basics. Roth IRAs are beloved by CPAs for a few simple reasons. You put in money after-tax, but after it’s in, the balance grows tax-free. So even if your balance grows from a few thousand dollars upon inception to a million or more by the time you retire, your distributions upon retirement will be totally tax-free. So, if you expect to be at a higher tax bracket upon retirement than you are now, Roths are considered a very good deal.
And unlike regular IRAs, Roths do not have required distribution mandates, so you can let your money grow as long as you like. But Roths do have strict income limits. For this year, anyone making more than $139,000 as an individual, or $206,000 for a married couple filing jointly, cannot contribute to a Roth. However, somewhat inexplicably, it’s perfectly legal for anyone making over that amount to contribute to a regular IRA (a max of $6,000 this year, or $7,000 if you are 50 or over and doing a “catch-up” contribution), then “convert” to a new or existing Roth where—voilà!—the balance grows tax-free.
Why is this a particularly good strategy during a bear market? As Knoll explains, if the money inside your traditional IRA has never been taxed, you will need to pay some taxes when you ultimately convert. “That tax due is in part based on the value of the investments inside at the time of conversion,” she explains. “So if I convert when values are pummeled, my tax hit is smaller, and once everything recovers, that appreciation never gets taxed.”
That said, there are several considerations to be aware of.
And if you end the year with a zero balance in your traditional IRA? At least it’s something you can feel good about.
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