Is a Down Market the Right Time for a Roth Conversion?
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While a down market may be cause for concern for some, it’s an opportunity waiting for others. One such opportunity may be a Roth IRA conversion.
For most investors, 2022 has been a year full of uncertainty. Soaring inflation and unease over the economy have sent stocks reeling, leaving depressed retirement account balances in their wake. However, if you're looking for a silver lining amid the turmoil, there's this: You could be saving a lot of money on your tax bill if you choose to perform a Roth IRA conversion, whether the market is down or not. Find out why that's the case and whether converting your account is right for your long-term objectives.
What is a Roth IRA conversion?
A Roth IRA conversion involves taking money or securities from a tax-deferred retirement account such as a traditional IRA or 401(k)—where you typically contribute pre-tax dollars—and putting them into a Roth IRA.
Unlike traditional retirement accounts, you can't claim an income tax deduction on the money you contribute to a Roth IRA. However, your money grows on a tax-deferred basis and you can make completely tax-free withdrawals in retirement; to do so, you have to be at least 59½ and have owned the account for at least 5 years.
For workers who anticipate being in a higher tax bracket later in life, that switch can be a smart financial strategy. However, you do have to pay income tax on any pre-tax contributions that you convert, so you may need a significant cash reserve to pull it off.
Is now a good time for a Roth IRA conversion?
While the current 2022 market downturn is gut-wrenching for investors, it may be the perfect time to convert your pre-tax contributions to a Roth IRA. Why? You'll be paying income tax on a smaller portfolio balance.
Let's say you have a traditional IRA that was valued at $100,000 at the beginning of the year. At that point, you would've had to pay income tax on that entire $100,000 if you wanted to convert to a Roth IRA. But let's assume, given sliding stock prices, that your account balance drops to $80,000. Now you're paying income tax to convert that smaller amount. That could equal some big savings.
Of course, depending on the size of your savings and your tax rate, a conversion can still trigger a hefty tax bill and count toward your gross income for that year.
Who should consider a Roth IRA conversion?
Paying taxes now in exchange for tax-free withdrawals in retirement may be advantageous for some investors but not others. In general, a Roth IRA conversion makes sense if:
You expect your income to rise. Obviously, you'd rather pay income taxes when you're facing the lowest-possible tax rate. If you feel that your peak earning years are still ahead of you or you simply want tax diversification, converting some or all of your retirement assets now could be a wise move.
You're concerned about taxes increasing. The Tax Cuts and Jobs Act of 2017 lowered marginal tax rates but only temporarily. Without additional legislation, they’ll revert to the higher, pre-TCJA rates in 2026. If that does come to pass, you may be better off paying tax at today's rates.
You want to avoid RMDs. Workplace plans and traditional IRAs come with required minimum distributions (RMD’s) that you have to start taking at age 72 (or age 70½ if you reached that milestone before January 1, 2020). Roth IRAs, on the other hand, don't have RMDs. So if you don't anticipate having to lean on your retirement account for income, a Roth IRA potentially allows you to leave more assets for your heirs.
You have the money to cover the taxes. Performing a Roth conversion during a bear market may have its benefits, but you nonetheless might be stuck with a large tax bill. Pulling assets out of your retirement plan, or electing tax withholding to pay the tax, will trigger a 10% early withdrawal penalty on the amount held if you are under 59½, so you'll need cash on hand to cover your liability.
That said, converting money to a Roth IRA account may not be right for everyone. Since 2018, you're no longer allowed to “recharacterize” your Roth conversion, which is essentially like "unconverting" your conversion. So, if you elect a Roth conversion as part of your long-term strategy, you want to be absolutely certain that it's in your best interest. The money you convert counts as taxable income for the year, so you'll want to make sure it doesn't push you into a higher bracket.
Additionally, keep in mind that unlike money you invest directly into a Roth IRA (not through a conversion), you can't immediately access your contributions tax-free. The funds have to be in your account for at least five years; otherwise, you'll face the 10% early withdrawal penalty.1 You may also want to tread carefully if you're a retiree and a distribution would affect your Medicare premiums or affect the tax treatment of your Social Security benefits.I
The Bottom Line
Undoubtedly, choosing if, when and how to perform a Roth IRA conversion involves a lot of factors. Collaborating with your financial advisor and tax professional can help you weigh the pros and cons, keep an eye on the market and create a conversion strategy that best serves your financial needs.