Three Ways to Move Money Into a Roth IRA
Thursday, September 17, 2015

Before discussing this week’s topic: Roth IRAs, I want to share a quick observation about today’s Federal Open Market Committee (FOMC) statement. Not only were interest rates left unchanged—as you may have already heard, but forecasts for where the fed funds rate will be over the few years were lowered…again. One FOMC member thinks additional monetary stimulus may be needed this year or next. Just four committee members expect the fed funds target rate to be above 2% by the end of 2016; two months ago, six members shared this forecast. Even the highest longer-run forecast was cut from 4.25% to 4%. It’s worth noting that a Financial Times survey posted yesterday showed 47% of surveyed economists expected a rate hike to be announced today…an indication of just how difficult it can be for even the pros to accurately predict monetary policy and future inflation.

The committee’s forecasts can be seen by looking at the “dots,” meaning the charts included in the release of the FOMC’s economic projections. (You can see the current set of forecasts and those from previous meetings on the Federal Reserve’s website. Click on “PDF” under “Projections Materials” for a given meeting).

There are three strategies for contributing to a Roth IRA: directly opening or contributing to a Roth IRA, making a Roth IRA conversion and using a backdoor Roth IRA.

There is a reason why I am bringing this topic up now. The year is already more than two-thirds over. As such, you have a good idea of what you will report in terms of income, expenses and deductions on your 2015 tax return—exclusive of, obviously, any surprises that may yet occur. Furthermore, September has also been the worst-performing month for stocks since the end of World War II. With most exchange-listed stocks currently down more than 10% from their 52-week highs, it may be cheaper now to convert traditional IRA holdings to a Roth IRA than it was a month or two ago. Though we don’t think current and future taxes should be the tail that wags the dog, there is upside to using the tax laws and rules to your advantage.

The easiest way to move money into a Roth IRA is to simply open an account and fund it. Married couples with adjusted gross incomes (AGI) below $183,000 can contribute up to $5,500 ($6,500 for those ages 50 or older). The income limit for single filers is $116,000. The key word is income; those without earnings are not eligible. Unlike the next two strategies, contributing to a Roth IRA does not impact your 2015 taxes since contributions are made with aftertax dollars. Future taxes, however, will be reduced relative to the then-prevailing rates. As an added bonus, withdrawals won’t be taxed and Roth IRAs are not subject to the required minimum distribution (RMD) rules.

The second way is to convert traditional IRA assets into a Roth IRA. Roth IRA conversions do not have any income limits, but the amount converted is taxable at your marginal tax rate. For example, a couple in the 28% tax bracket who converts $10,000 to a Roth IRA will incur $2,800 in tax liabilities. This is a one-time tax and any future earnings on the amount converted will not be taxed under existing tax law. An additional advantage of at least running the numbers on a conversion now is that there is still time to realize offsetting deductions (e.g., capital losses, charitable donations, medical expenses such as new hearing aids, etc.)

The downsides of a Roth IRA conversion are that it creates a tax liability in the current tax year and it may not make as much sense if there is reasonable expectation of being a lower tax bracket in the future. The tax liability issue requires knowledge of the tax brackets and ensuring the amount converted is not so much that it bumps you into a higher income tax bracket or triggers other income-related taxes. For those expecting to be in a lower tax bracket in the future, the decision rests more on the desire to diversify tax exposure and to have more control over when portfolio withdrawals will be made in the future.

A third way is a backdoor Roth IRA. Under this strategy, the maximum deductible amount ($5,500/$6,500) is contributed to a traditional IRA. The contribution amount to the traditional IRA is then converted to a Roth IRA. The two-step process allows for both a tax deduction on the contribution to be realized immediately and for future withdrawals from the Roth IRA to be made tax free. Though this sounds like a win-win tax strategy, it’s not without complications.

If the contribution to the traditional IRA is nondeductible [e.g., due to high income, the account holder participates in a 401(k) plan, etc.], then it cannot simply be converted to a Roth IRA. Rather, the IRS requires that the conversion amount include both deductible and nondeductible balances on a pro rata basis. The pro rata calculation must be based on the amounts held in all traditional IRAs, which may mean that most of the contribution intended for the backdoor Roth IRA may not be eligible to be used for the Roth IRA conversion. Real Deal Retirement editor Walter Updegrave says this fact may make a traditional Roth IRA conversion the better option from a tax standpoint.

There is also a timing issue with backdoor Roth IRAs. If the IRS believes there was the intent on the part of the taxpayer to use a backdoor IRA, it can deny the conversion and impose penalties. The way to avoid this is to wait between one month and 12 months between contributing to the traditional IRA and then executing a Roth IRA conversion, observes Pinnacle Advisory director of research Michael Kitces.

More on AAII.com

The Week Ahead

Nearly 15 members of the S&P 500 will report earnings next week, most of which are early third-quarter reporters. Included in this group is Dow component Nike (NKE), which will report on Thursday. Other notable companies are Lennar Corp. (LEN) on Monday; Carnival Corp. (CCL) and General Mills (GIS) on Tuesday; and Accenture (ACN) on Thursday.

The first economic report of note will be August existing home sales, released on Monday. Wednesday will feature the PMI’s September manufacturing index flash. August durable goods orders and August new home sales will be released on Thursday. Friday will feature the second revision to second-quarter GDP and the University of Michigan’s final September consumer sentiment survey.

Federal Reserve Chair Janet Yellen will make a public appearance on Thursday. Also scheduled to make public appearances are Atlanta president Dennis Lockhart—who will speak on Monday, Tuesday and Wednesday—and Kansas City president Esther George on Friday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

Pessimism fell to an eight-week low, ending a streak of seven consecutive weeks with above-average readings, in the latest AAII Sentiment Survey. Neutral sentiment rebounded, while optimism declined modestly.

Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 1.4 percentage points to 33.3%. The decline keeps bullish sentiment below its historical average of 39.0% for the 28th consecutive week, the longest such streak since a 29-week stretch in 1993.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 7.3 percentage points to 37.6%. The rebound puts neutral sentiment back above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 5.9 percentage points to 29.1%. This is the lowest level of pessimism registered by our survey since July 23, 2015 (25.6%). The historical average is 30.0%.

Rising stock prices over the survey period combined with a decrease in market volatility helped to lessen some of the pessimism registered in our survey. This said, it is too early to say whether this week’s results imply a shift in attitudes or just a one-week change. Though some individual investors were encouraged by the decline in valuations that occurred in late August, others remain concerned about the possibility of stock prices falling further due to valuations, slow earnings growth and slow economic growth. It’s worth noting that bullish, neutral and bearish sentiment all remain within their typical historical ranges.

This week’s special question asked AAII members what industries or sectors they like right now. Nearly 40% of all respondents said health care, with many specifically listing biotechnology. Energy was picked by about 20% of respondents, followed by technology (17%), financials (15%) and consumer staples (16%). Many respondents listed more than one industry or sector.



This week’s Sentiment Survey results:

Bullish: 33.3%, down 1.4 points
Neutral: 37.6%, up 7.3 points
Bearish: 29.1%, down 5.9 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
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