Unless you have some niche investments, the value of your portfolio is probably down at the moment. The S&P 500 is up about 18% over the past 12 months, and the broad bond market hasn’t fared much better, having lost 13%.
But depending on your tax situation and the types of accounts you have, now may be an excellent time to move money from a traditional IRA to a Roth account, a move known as a Roth conversion.
Because Roths are funded with money you pay taxes on upfront, you̵[ads1]7;ll owe a bill on any investments you roll over. But the less these investments are worth, the less you pay in tax.
“Because the market is down, now is a great time to talk about Roth conversions,” says Brian Schultz, a CPA and tax partner at accounting and wealth management firm Plante Moran. “Converting at a lower cost than normal has been huge for some investors who have been able to take advantage of that.”
Here’s why financial pros say a Roth conversion could be a worthwhile move right now for anyone considering it.
Traditional vs. Roth IRAs: “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, meaning you can deduct any contributions you make in a given year from your taxable income. But because you’re forgoing taxes upfront, you’ll owe them when you withdraw the money in retirement. You also owe a 10% penalty if you withdraw the money before the age of 59½.
Roths, on the other hand, come with no upfront deductions since you fund these accounts with money you’ve already paid taxes on. But when you turn 59½, provided you’ve held the account for five years or more, you can withdraw all your money, including investment gains, tax-free. And you’re allowed to withdraw up to the amount you’ve contributed at any time without penalty.
Which account makes sense for you depends on your individual financial situation, but generally a Roth is recommended if you expect to pay lower taxes now than when you retire. That’s why many financial pros recommend Roth IRAs for early-career investors whose salaries are likely to increase and push them into higher tax brackets.
Remember that the authorities can raise taxes too. But because any income you earn from a Roth in retirement is tax-free, these accounts can provide peace of mind for investors of all ages, says Ed Slott, a certified public accountant and founder of IRAHelp.com.
“Your money just grows for you tax-free for the rest of your life, making conversion a good hedge against 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 reasons above can make a Roth conversion attractive to anyone who fears their tax rate may be higher in retirement, it can be especially useful for young workers who expect to earn more income toward the end of their careers and near-retirees who fear that they will owe higher taxes on their IRA distributions if the government raises tax rates.
If that sounds like you, now might be the time to do it.
Because you haven’t been taxed on any of the money in your traditional IRA, you’ll owe taxes if you convert to a Roth. But if the value of your portfolio is down right now, it’s cheaper than usual to move your stocks over.
Say you own 10 shares of an ETF, each worth $100, in your traditional IRA. If you convert it to a Roth, you’ll owe taxes on the dollar value of the shares: $1,000. But if your portfolio went down 20%, you could move those same 10 stocks over and pay taxes on $800.
Once your stocks are converted, they will ideally continue to grow tax-free in your Roth account until you’re ready to withdraw the money at retirement.
“There’s no question if you pay for something and it costs less, that’s good,” says Slott. “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 can 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 between now and 2026, when the lower tax rates set forth in the Tax Cuts and Jobs Act are set to expire.
“You can do it this year, then again in 2024 and 2025, and then, by current law, the party is over,” says Slott. There is no limit to how much you can convert in a single year, nor to how many conversions you can make.
Beware of the disadvantages
Like almost anything involving taxes and investments, Roth conversions are complicated moves that are best done under the supervision of a trusted professional.
There are also some disadvantages to be aware of when deciding whether this is a smart move for you.
First, they are permanent. You are no longer allowed to “recharacterize” your Roth conversion back to a traditional IRA. If you convert any of your investments, the tax bill is due, even if a financial emergency drains your cash reserve between the time of the conversion and tax day.
Depending on how much money you’re moving over, doing a conversion can mean a big income stream—potentially enough to push you into a higher bracket. That, in turn, can disqualify you from certain tax breaks.
And don’t convert money you need soon. You can’t withdraw your converted Roth funds, or their earnings, for five years after you switch, regardless of your age. If you do, you will owe tax on the amount withdrawn plus a 10% penalty.
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