Ed Slott: Turn lemons into Roth conversion cash

Many clients have significant amounts of unrealized losses from the turmoil in the financial markets. Selling those assets can provide a “bank” of net capital losses. Then the client can sell some of his or her appreciated capital assets, which can be sheltered from tax by the net losses and increase the amount of cash that can be used for a Roth conversion. Suppose, for example, that a financial adviser looks over Richard's financial statements and sees that he has $2 million of portfolio assets. Included are $200,000 worth of stocks and funds bought for $300,000. If Richard sells those stocks and funds, he will have a net capital loss of $100,000. Typically, some of the losses will be short-term and others long-term, but it makes no difference for this purpose. Let's also assume that Richard's adviser helps him select $150,000 worth of stocks and funds to sell at a profit of, say, $30,000. Thanks to his bank of $100,000 worth of net capital losses, Richard will owe no tax on his $30,000 of gains. If he ends the year in this position, he will pay no capital gains tax and still have $70,000 of net capital losses. Richard can deduct $3,000 against his ordinary income and carry over $67,000 to future years to offset future gains. Moreover, he now has $350,000 in sales proceeds: $200,000 from taking losses and $150,000 from taking gains. Richard can use that $350,000 to pay the Roth IRA conversion tax and keep his entire remaining portfolio in the Roth IRA. The investment sales produced net losses, so there is no tax cost to creating the cash to pay the tax on the conversion, plus those capital gains no longer will be exposed to the 3.8% health care taxes coming in 2013. Roth conversion income is ordinary income, not capital gains income. Capital losses can offset Roth conversion income only up to $3,000 a year. For example, you can't use a $100,000 capital loss to offset a $100,000 Roth conversion. It can offset only $3,000, and the rest of the loss is carried over to future years. Capital losses, though, do offset capital gains. Inside his Roth IRA, Richard can make a wide variety of investments. Can he use some of the Roth portfolio money to replace securities he sold to raise money to pay the tax? The Internal Revenue Service says yes, no and sometimes. If Richard wants to replace the securities he sold at a profit, he can immediately buy them in his Roth IRA. The wash sale rules apply only to losses, not to investments sold at a profit. However, the IRS has indicated that a taxpayer can't take a capital loss and immediately buy back the same asset in an IRA. If Richard sells $50,000 worth of Company A stock at a loss and immediately invests $50,000 in the same stock in his Roth IRA, the IRS may call the transactions a wash sale and disallow his capital loss on the original sale of the stock. Instead, Richard can sell the Company A Stock and immediately buy another position, perhaps Company B stock, within his Roth IRA. Alternatively, he can sit on the sidelines for 31 or more days and then buy Company A in his Roth IRA, with no wash sale consequences. Some clients may already have taken most or all of their capital losses. If so, they might have a bank of losses carried over from prior years or losses realized this year. Such clients can take capital gains, tax-free, until they have used up all their realized losses. The sales proceeds from taking profits can be used for conversion taxes. What if a client has unrealized gains but no capital losses, realized or unrealized? You might suggest that such clients consider selling this year, while the 15% maximum tax rate on long-term gains still applies. This rate is increasing to 20% next year and will be exposed to the 3.8% health care tax in 2013 (for those at higher income levels), bringing the rate to 23.8%, not including any state taxes that might apply. With the above examples of tapping capital assets for Roth IRA conversion taxes, the amounts left in taxable accounts will be reduced. That may mean less taxable investment income in the future and less exposure to the 3.8% surtax on unearned income. Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.