How to Arbitrage Your U.S. Taxes for Difficult Economic Times

Pandemic-induced market volatility and warnings from Wall Street that tax rates are bound to rise have more Americans preparing to move money from traditional individual retirement accounts into Roth IRAs.

It’s an attempt at tax arbitrage. With traditional IRAs, a saver is required to begin making annual withdrawals and paying income taxes on them at age 72. If tax rates are likely to be higher then, the thinking goes, why not pay taxes on some of the money held in tax-deferred accounts now, at today’s presumably lower rate, and let it grow tax-free in a Roth?

That option has become more appealing this year, as stock market declines have shrunk the value of accounts, along with the tax bill for converting assets. Fidelity Investments said Roth conversions surged 76% in the first quarter from a year ago.

The strategy can also make more sense for those in lower tax brackets due to job losses or salary cuts. As well, the CARES Act allows those required to take annual distributions from traditional IRAs to skip it this year, which can provide wiggle room within their tax bracket for maneuvers like a partial Roth conversion.

Daniel Lash at VLP Financial Advisors in Vienna, Virginia, did Roth conversions for about 10 clients in late March and early April, as equity markets were at their lows for the year.

“We moved mostly small- and mid-cap U.S. stock funds, and since completing the conversions the funds have increased significantly, but now on a tax-free basis in the Roth,” he said.

The S&P 500 has surged 31% since bottoming out on March 23.

Some people assume they’ll be in a lower tax bracket when they retire. But a growing number of Wall Street luminaries predict that personal or corporate tax rates will probably rise as massive government stimulus programs swell federal budget deficits. They include BlackRock Inc. Chairman Larry Fink, Bridgewater Associates’ founder Ray Dalio and Goldman Sachs Group Inc. chief U.S. equity strategist David Kostin.