During periods of extreme market volatility, like we’ve had during the first quarter of 2020, wise long-term investors will find ways to channel their angst (over things they can’t control) into taking a strategic look at their accounts for potential long-term tax planning opportunities.
For those of us who have both traditional (pre-tax) IRAs and Roth IRAs, now is a good time to review the types of investments held in each of those accounts. As a quick review, here are the tax treatments of different types of income in each of these accounts:
- Your original (pre-tax) contributions to the account will be taxed upon distribution at ordinary income tax rates (similar to wages)
- Dividends and interest are tax deferred while they remain in the IRA, but will be taxed as ordinary income when they are distributed from the account
- Capital gains are tax deferred while they are in the IRA, but they will also be taxed as ordinary income when they are distributed from the account (unfortunately, they do not qualify for the more favorable long-term capital gains tax rates)
- Your original (after-tax) contributions to the account will not be taxed upon distribution
- Dividends, interest, and capital gains earned are tax free while in the Roth and no tax is owed upon distribution
Based on the significant difference between taxation of distributions from these two accounts (all taxed as ordinary income vs no tax at all), the most aggressive long-term investments in your overall portfolio (typically US, International, and Emerging Markets stock funds) should be held in the Roth. Your overall allocation to bond funds are better suited for the traditional IRA since they are less likely to grow over time, and the income (dividends) they generate will benefit from the tax deferral offered by the IRA until you make distributions.
Below is a simplistic example of an investor who has both a traditional IRA and a Roth IRA with identical balances of $250K at the beginning of the year, as well as identical stock vs bond allocations of 60% and 40%, respectively.
After experiencing a 33% stock market downturn (similar to what we experienced during the first quarter of 2020), their accounts now look like the following:
Now, let’s assume that 1) this investor doesn’t make any changes to their portfolio, 2) the bond funds hold their same value over the next 10 years, and 3) the value of the stock funds not only recovers the $100K from the recent market drop, but also increases by another $100K over 10 years. If this investor distributes all of their investments from both accounts after 10 years and pays an effective tax rate of 25%, the results would be as follows:
Alternatively, if this investor had rebalanced their holdings right after the current market downturn, and effectively transferred as much of the stock fund holdings ($100K) as possible from their traditional IRA to their Roth IRA, the pre-recovery portfolio would have looked like this:
When this portfolio experiences the same recovery as the original portfolio, and the full distribution takes place after 10 years, the after-tax proceeds are now $25K higher, as shown below.
In summary, the investor in the example above has significantly reduced their lifetime taxation on total IRA distributions without taking on any additional risk by simply holding different allocations of investments in their accounts over an extended market recovery. If you have multiple types of IRAs and have been impacted by the market downturn, this is a perfect time for you to take a close look at your allocations to see if you might benefit from some long-term tax planning through strategic rebalancing in the accounts.
Paul Hansen, CFP®, CPA