By Ryan O’Leary
Dividends, whether from stocks, ETF’s or mutual funds, are taxable in the year that they are received. As such, they are taxable as income whether you take them in the form of distributions to supplement your income or reinvest them. My question to clients who have both a taxable account and a Rollover IRA is why not use the reinvested dividends to fund a Roth conversion every year instead? The dividend income can be used to pay the taxes on the Roth conversion.
Here is an example:
A client has a $200,000 joint investment account that generates $6,000 of 1099 reportable dividend income every year. Let’s also say they are still working but have a $300,000 rollover IRA from a previous employer.
If they are in a 22% tax bracket, the $6,000 of dividends that they normally just reinvest will buy them approximately $27,272 of Roth conversion funds ($6,000/22%) on the Rollover 401k.
Assuming they do that in years when the additional income will not cause any other adverse tax consequences, this could lead to that highly coveted Roth nest egg in retirement or for legacy purposes. And now with the passing of the Secure Act and the elimination of non-spouse stretch IRA provisions, Roth IRA’s can be an even more valuable piece of the wealth planning puzzle.
This strategy is most effective when using stocks and ETF’s with known taxable dividends received throughout the year rather than mutual funds where the capital gains distributions are less visible prior to year-end. Although most mutual funds will publish an estimate of capital gains distributions. Unlike IRA contributions, conversions must be done by the end of the calendar year rather then by the April tax deadline.
You can also add in harvested tax losses in the taxable accounts to create an even more aggressive Roth conversion strategy. In other words, use any realized tax losses throughout the year to offset a Roth conversion strategy in addition to the taxable dividends used.
Remember, unlike Roth IRA contributions there is no income limit to convert IRA funds to Roth IRA funds. Using taxable dividends to fund Roth conversions is a great way for higher income earners to get money into a Roth, preferably prior to 5 years before retirement to get around the 5-year rule for Roth IRA initial funding contribution.
This strategy is designed to be relatively painless way to develop a long-term Roth conversion strategy by minimizing the “out of pocket” cost that is often viewed as a Roth conversion deterrent.
Ryan O’Leary, CFP ® is a Senior Vice President, Investments with Rockport Global Advisors and a subscriber to MyPerfectFinancialAdvisor