How to Take Advantage of Roth Conversions in a Down Market
Down markets like we have been experiencing can keep you up at night. But downturns also present opportunities (see our article on tax loss harvesting). One of those opportunities is converting your traditional IRA into a Roth IRA. Read on to find out why you may want to do a Roth conversion and why a market downturn can be the ideal time for one.
Why Do a Roth Conversion?
Roth IRAs and Roth 401(k)s are taxed differently than your traditional IRA or 401(k). With the latter, you reduce your taxable income now but must pay taxes when you make withdrawals in retirement. You also must withdraw a minimum amount each year once you reach age 72—whether you need the money or not. And, of course, you’ll pay taxes on those required minimum distributions (RMDs).
Roth plans don’t have RMDs. Their growth and distributions are also tax-free. Bear in mind that our current tax brackets will sunset in 2025 unless Congress moves on that. After 2025, tax brackets will rise to the higher 2017 rates. If you expect your income taxes to increase in retirement, you might consider incorporating Roth accounts into your retirement plan. Talk to a financial advisor about the appropriate mix of retirement accounts for your situation and goals.
If you’re a high-income earner, your ability to contribute to a Roth IRA phases out as your income climbs. Once your modified adjusted gross income reaches $144,000 for single taxpayers in 2022 or $214,000 for married couples filing jointly, you cannot contribute.
That’s where a Roth conversion comes in. You don’t have to worry about income limitations when converting an IRA to a Roth, making a conversion a potential tool for your retirement savings.
Even if you can convert to a Roth IRA, you may want to use this strategy if you have a sizable traditional IRA and want to enjoy a Roth’s tax-free distributions in retirement.
Why Down Markets Are a Good Time to Make a Roth Conversion
When you complete a conversion, you must pay taxes on the amount you moved from the IRA to the Roth. Depending on the amount you converted, the taxes could be substantial.
This is where volatile markets have a role to play. Your portfolio value will drop, and the reduced value equates to fewer taxes owed. Once the markets and your portfolio value climb again, you will owe more taxes than if you had decided to do the conversion before the markets shot up.
Consider the Roth conversion as a silver lining in the storm clouds of market downturns. However, there are some considerations:
Make sure you have money on hand to pay the taxes. You will have to pay income taxes for the year you make the conversion. Pulling funds from another retirement account to cover the taxes could incur more taxes and, potentially, penalties. So make sure you have the cash for your tax bill.
Feel confident you won’t need the money for five years. If you withdraw your converted Roth IRA funds before five years, you could get dinged with a 10% early withdrawal penalty. This rule can get tricky, especially if you have multiple conversions. Read this Investopedia article to learn more.
Be aware of the potential impact on Social Security or Medicare. If you receive Social Security or Medicare, or plan to within the next couple of years, talk to your financial advisor before completing a Roth conversion. The boost in your MAGI could increase your Social Security taxes or premiums for Medicare Parts B and D.
Final Thoughts
A Roth conversion could help increase your tax flexibility in retirement. It can also enable you to open a Roth IRA if your income normally prevents Roth contributions. Converting in a down market could help reduce your taxes since your portfolio will be worth less.
But does a Roth conversion make sense for you? Our fiduciary retirement planning firm helps clients determine the appropriate down-market strategies, including Roth conversions, as part of their overall retirement planning and investment management.
We offer a complimentary 15-minute call to discuss your financial situation and concerns and share how we may be able to help.
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