We want to start this article with a disclaimer: This article is stating the ideal situation for a Roth conversion, not necessarily the only time when a conversion would be advantageous.
With that being said, we’ll get right to it! One of the best opportunities you can take advantage of during a stock market pull back period is to execute a Roth conversion. This could help you save money on taxes on subsequent growth and withdrawals after the stocks bounce back.
For example: in May of 2022, the S&P 500 was down over 17% YTD. Since January of that year, stocks, indexes, and equities faced a massive slump, largely due to the Russia-Ukraine war, skyrocketing inflation, and the growing concern of a recession.
While other investors stressed over the bear market, some only saw opportunities.
Here’s everything you need to know about a Roth IRA conversion.
What Is a Roth Conversion?
A Roth IRA conversion involves moving your funds from a traditional IRA, or a standard 401k, to a Roth IRA account.
The initial contribution (pre-tax dollars) and growth are tax-free in a traditional IRA. Funds are taxed after withdrawal at ordinary income tax rates.
In contrast, a Roth IRA is funded with after-tax income, so there are no upfront tax benefits. Initial contributions to a Roth IRA are taxed at ordinary income tax rates, while the subsequent withdrawals and growth are tax-free. This means that a Roth conversion is a taxable event, with the taxes remitted for the year the transfer occurs.
Who’s Eligible for Conversion?
Anyone with a traditional IRA can move their traditional IRA funds to a new or existing Roth account. The IRS also accepts the rolling over of distributions from other qualified retirement plans, such as a 401(k), 403(b), and 457(b).
You can convert your IRA to a Roth account at any time. However, the process may need to be completed before December 31st to enable you to include the income in your current tax year. If it is not finished by this day, the tax obligations run over to the next year.
What Are the Benefits of the Roth Conversion?
Moving your funds to a Roth IRA account can provide excellent tax savings during these market dips. You can reduce your taxable basis and the total amount you pay over the long term.
For example, suppose your traditional IRA account was $100,000 as of December 31, 2021. If you were in the 24% tax bracket, you might have had tax obligations totaling $24,000 if you decided to execute your Roth conversion in January.
With the prevailing bearish market, your portfolio may be down 16% YTD, settling at $84,000. If you make your Roth conversion today, your tax implication stands at $20,160. Without additional penalties, you can save $3,840 on your taxes.
You can also view the benefits of investing in a Roth account from your traditional IRA to own more shares. The down market can provide discount prices for high-value stocks that will bounce back after the correction ends.
If the market recovers, you have more free dollars to invest from the tax savings made in your investment portfolio. Other benefits of Roth IRAs include:
- You aren’t tied to the required minimum distributions (RMDs) common to the traditional IRA
- You can withdraw your earnings tax-free and penalty-free after a five-year restriction
Talk to a CPA to determine whether it’s the right time to take your traditional IRA to a Roth account.
How Should You Pay the Tax Bill on Your Roth IRA Conversion?
You need to carefully plan how to honor your tax obligation for the Roth conversion. Taking the money from the conversion to pay the tax bill might defeat the purpose.
Suppose that you take out the $20,160 from your traditional IRA to pay the taxes. While it may not seem like a lot, compound interest means that you may lose out on money growth when the markets bounce back. The $20,160 has the potential to grow to over $93,964 over 20 years at an 8% interest rate.
Consult a financial planner to understand how best you can fund the tax bill without taking on extra debt.
What Are the Drawbacks for the Roth Conversion?
A Roth conversion is not without risk. You might not benefit if your tax rate becomes lower in the future. In addition, you have to wait for five years after the conversion to make penalty-free deductions from your account.
Figuring out your taxes can become complex, and good retirement planning requires the services of a tax professional or planner.
Should You Convert Now?
With a Roth conversion, you can transfer funds from your 401(k) or traditional IRA account to a Roth IRA. Roth IRAs can be an effective way to grow your retirement savings and reduce taxes. You may need to hire a CPA to inform you about the tax implications of the conversion.
As a Wealth Management Firm specializing in Retirement Planning, we help our clients execute Roth Conversions on a regular basis. If you or someone you know could benefit from meeting with us, please feel free to schedule an introductory call with us (click on this link to schedule your call).
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