While a down market may not be a fun time for investors, there are some bright spots and opportunities to be had. Stock market drops like we’ve seen recently might make a Roth IRA conversion more appealing as a strategy for investors.
Should you consider converting a traditional IRA to a Roth during a down market? There are a few things to consider before pulling the trigger.
What is a Roth Conversion?
Before you embark on a Roth conversion, you need to fully understand what it is. When you have a traditional IRA, those are pre-tax dollars that you’re investing. While the money grows tax-free, when you later go to take a withdrawal, every dollar you pull will be taxed.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
With a Roth IRA you are investing post-tax dollars, and when you convert a traditional IRA to a Roth, you pay the full tax during the year that you convert, at ordinary income rates. Then, the dollars that you’ve converted will grow tax-free for the remainder of the time that they sit within the investment. When you later take money out of a Roth, it’s all tax-free, as long as you are 59½ or older and follow a few other rules.
What You Need to Know About a Roth Conversion in a Down Market
When you trigger a Roth conversion, you’ll be responsible for paying the tax due on any pre-tax contributions or earnings within the traditional IRA. The benefit here is that if the market has dropped, it’s likely that your IRA value has dropped along with it – so your full value has gone down, and you’ll be paying taxes on the current value (which is lower, due to the market being down than it was months ago). So, in theory, you can convert a larger portion of your IRA in a down market and pay less in taxes than you could in years when the market is up.
Here's an example: If you had a traditional IRA with $100,000 at the start of the year, and due to the market, it is now down to $85,000, you could choose to convert that entire IRA to a Roth and only pay tax on the $85,000 instead of the $100,000 that it was months ago. Assuming that these dollars will rebound in the market in the future, you’ve picked a good opportunity to convert.
It’s important to work with both a financial adviser and your tax professional to determine not only the amount of tax you’ll owe during the year that you perform the Roth conversion, but also how long it would potentially take you to break even.
What are the Pros of a Roth Conversion?
Converting from a traditional IRA to a Roth has many potential benefits for investors. Because a Roth IRA allows for dollars to grow tax-free, all the growth is also tax-free. There are also no RMDs, or required minimum distributions, on a Roth IRA once you turn 72. With a traditional IRA or 401(k), you have a set minimum you must withdraw each year once you hit RMD age, but Roth IRAs do not adhere to this rule.
Income tax rates are still relatively low, historically, which means now is as good of a time as any for a Roth conversion, from a tax perspective. Tax parity is another benefit of Roth IRAs because you have different “buckets” of income to pull from at retirement in an effort to keep your taxes low during retirement. Roth IRAs also benefit your spouse and heirs at inheritance time, as the tax-free benefits pass along to them in various ways, depending on the time limit and amount, and their relationship with you, the deceased.
A Few Cautions on Conversions
Roth IRA conversions aren’t all benefits though, there are a few things to be aware of. There’s the five-year rule, where you must wait five years after a conversion before making a withdrawal or else you could incur a 10% penalty. Keep in mind that this five-year rule only applies to those who are younger than 59½. After you reach that age, the five-year rule and its penalties no longer apply.
Triggering a Roth conversion may also increase your adjusted gross income (AGI), which could compound other issues, such as Medicare premiums. This may also increase your tax rate.
The best way to determine if a Roth conversion is the right move for you during the down market is to work with a financial adviser and a tax professional so you can get feedback on your specific financial situation.
Diversified, LLC does not provide tax advice and should not be relied upon for purposes of filing taxes, estimating tax liabilities or avoiding any tax or penalty imposed by law. The information provided by Diversified, LLC should not be a substitute for consulting a qualified tax adviser, accountant, or other professional concerning the application of tax law or an individual tax situation.
Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax adviser for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
-
The $1 Million Retirement Question: Are You Being Tax-Smart About Your Pension?A financial planner raises some key considerations for navigating retirement with a pension and recommends four strategies.
-
The Costly Mistake You Might Be Making With Your First 401(k)Most people start contributing to their retirement savings later in life. That could be a big-time mistake, literally costing you thousands of dollars.
-
An Estate Planning Attorney's Guide to the Importance of POAsRegularly updating your financial and health care power of attorney documents ensures they reflect your current intentions and circumstances. It's also important to clearly communicate your wishes to your chosen agents.
-
Divorce and Your Home: An Expert's Guide to Avoiding a Tax BombYour home is probably your biggest asset, so if you're getting a divorce, the stakes are high. Keep it? Sell it? You need to have a good plan in place for how to handle it.
-
Fewer Agents, Fewer Audits: How IRS Staff Cuts Are Changing EnforcementSignificant reductions in the IRS workforce appear to be increasing the number of 'no change' audit closures. The shift could potentially increase the overall tax gap — the difference between taxes that should have been paid and those that were.
-
What if You Could Increase Your Retirement Income by 50% to 75%? Here's HowCombining IRA investments, lifetime income annuities and a HECM into one plan could significantly increase your retirement income and liquid savings compared to traditional planning.
-
Here's Why You Shouldn't Do an Estate Plan Without a Financial PlannerEstate planning isn't just about distributing assets. Working with a financial adviser can ensure you've considered the big picture — and the finer details.
-
Trump Tariffs and Taxes: Waiting to See What Happens Is Not a StrategyLike presidents, tariffs come and go. Policy changes also shift about every two years with the election cycle. If you're paralyzed by uncertainty, you could be missing opportunities to benefit your financial future.
