Unless you have niche investments, your portfolio value is probably down right now. The S&P 500 has fallen about 18% over the past 12 months, and the broader bond market hasn’t fared much better, down 13%.
But depending on your tax situation and the types of accounts you hold, now might be the perfect time to transfer money from a traditional IRA to a Roth account, a move known as a Roth conversion.
Because Roths is funded with money you pay taxes on upfront, you’ll have to pay a bill on any investments you move. But the less those investments are worth, the less tax you pay.
“Because the market is down, now is a great time to talk about Roth conversions,” says Brian Schultz, CPA and tax partner at accounting and wealth management firm Plante Moran. “The conversion at a lower than normal cost was huge for some investors who were able to benefit from it.”
Here’s why finance professionals say a Roth conversion could be an interesting move right now for anyone considering it.
Traditional IRAs vs. Roth: “You Can’t Beat a 0% Tax Rate”
To understand the benefits of a Roth conversion, it’s important to know the key differences between traditional and Roth IRAs.
Traditional IRAs are funded with pre-tax money, which means you can deduct all the contributions you make in a given year from your taxable income. But because you waive taxes upfront, you’ll owe them when you take the money out in retirement. You will also owe a 10% penalty if you withdraw the money before age 59.5.
Roths, on the other hand, has no upfront deduction since you are funding these accounts with money you have already paid taxes on. But once you turn 59.5, provided you’ve held the account for five years or more, you can withdraw all your money, including investment gains, tax-free. And you are allowed to withdraw up to the amount you contributed at any time without penalty.
Which account is right for you depends on your individual financial situation, but in general a Roth is recommended if you expect to pay less tax now than in retirement. That’s why many financial professionals recommend Roth IRAs to early-stage investors whose salaries are likely to rise and push them into higher tax brackets.
Keep in mind that the government can also raise taxes. But because all income you earn from a retired Roth is tax-exempt, these accounts can provide peace of mind for investors of any age, says Ed Slott, CPA and founder of IRAHelp. com.
“Your money grows for your tax-free income for the rest of your life, making the conversion a good hedge for higher tax rates in retirement,” he says. “You can’t beat a 0% tax rate.”
Why a bear market is a good time for a Roth conversion
While the above reasons may make a Roth conversion attractive to anyone concerned that their tax rate will be higher in retirement, it may be particularly useful for younger workers who expect to earn more income towards retirement. end of their careers and near-retirees who fear they’ll owe more taxes on their IRA distributions if the government raises tax rates.
If that sounds like you, here’s why now might be the time to do it.
Because you weren’t taxed on your traditional IRA money, you’ll have to pay taxes if you convert to Roth. But if the value of your portfolio is falling right now, it’s cheaper than usual to transfer your shares.
Say you own 10 shares of an ETF, each worth $100, in your traditional IRA. If you convert it to Roth, you’ll have to pay taxes on the dollar value of the stock: $1,000. But if your portfolio were to shrink by 20%, you could transfer those same 10 stocks and pay taxes on $800.
Once your shares are converted, they will ideally continue to grow tax-free in your Roth account until you are ready to withdraw the money in retirement.
“There’s no question that if you’re paying for something and it costs less, that’s fine,” Slott says. “But you don’t really know when the market is really down. It’s hard to time the market for a Roth conversion.”
As Slott points out, the market could rebound or fall further from current levels, so you’ll never know if you’re getting the best possible deal.
That’s why, if you’re interested in converting, he suggests planning a series of small conversions by 2026, when the lower tax rates set out in the Tax Cuts and Jobs Act are due to expire. .
“You could do it this year, then again in 2024 and 2025, and then the party, under current law, is over,” Slott said. There is no limit to the amount you can convert in a single year or the number of conversions you can make.
Beware of downsides
Like almost everything about taxes and investments, Roth conversions are complicated moves best done under the supervision of a trusted professional.
There are also a few downsides to consider when deciding if this is a smart move for you.
First, they are permanent. You are no longer allowed to “requalify” your Roth conversion to a traditional IRA. If you convert some of your investments, the tax bill falls due, even if a financial emergency depletes your cash reserve between the time of conversion and tax day.
Depending on the amount of money you’re moving, making a switch can mean a big influx of revenue, potentially enough to push you into a higher bracket. This could, in turn, disqualify you from certain tax breaks.
And do not convert the money you will need soon. You cannot withdraw your converted Roth funds, or their earnings, for five years after making the switch, regardless of your age. If you do, you will have to pay taxes on the amount withdrawn plus a 10% penalty.
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