(Sam Swenson, CFA, CPA)
As the broad market indices have declined by double digits since the start of the year, it makes sense to think about how you can make the most of the situation. Market downturns can present tax-planning opportunities, and it’s worthwhile to at least explore what some of those strategies might look like.
One of the best tactics on which to capitalize during a down market is the Roth conversion. In short, a Roth conversion involves moving money from a pre-tax retirement account (typically a traditional IRA) to a Roth IRA, a tax-exempt retirement account. Put another way, by converting assets from “pre-tax” status to “tax-exempt” status, you’re voluntarily paying tax now in exchange for a zero tax bill for the rest of your life. Needless to say, this can seem like an appealing option.
Below, we’ll discuss how this plays out in practice and what you should consider before converting.
Table of Contents
How does a Roth IRA work?
A Roth IRA is a retirement account that allows an investor to invest and grow their retirement money tax-free. Critically, money deposited in a Roth IRA has already been taxed, which is the mechanism that allows the Roth IRA to function as it does. Once assets are in a Roth IRA — and various holding-period requirements have been met — it will be exempt from income tax forever.
When you convert traditional IRA assets to a Roth IRA, it’s completely different from contributing money to a Roth IRA. A contribution is limited to $6,000 annually ($7,000 if you’re over 50) and is subject to various IRS income limits. A conversion, on the other hand, is unlimited. However, you’ll be liable for a hefty tax bill if you’re not strategic about how and when you perform the conversion.
What does a Roth conversion look like in practice?
This is the part that can get a little technical for people, but it can be made simpler with an example. A good first step in performing a Roth conversion is to first add the value of the estimated conversion to your total projected income for the year. This means adding your salary, freelance income, investment income, and any other income you have together with your potential Roth conversion amount.
If you have, say, $100,000 in total income and are thinking of converting $25,000 in assets from a traditional IRA to a Roth IRA, your total projected income for the year is $125,000. If you’re a single individual, this puts you, according to the 2022 Federal tax brackets, in the 24% marginal tax bracket. This means that the cost of the Roth conversion is simply 24% times $25,000, or $6,000.
You’ll pay $6,000 in current-year tax in exchange for never having to pay tax again on the $25,000 you converted. Since this tax exemption includes all growth and earnings (possibly for many decades), this can be a really enticing trade-off.
How can a market downturn lower the cost?
Imagine the same scenario as above, but instead, assume that, due to a market downturn, the value of your traditional IRA has fallen from $25,000 to $15,000. Following the same formula as above, you’d add $15,000 to $100,000 to arrive at $115,000 as your projected total income for the year. Since you’d still be in the 24% marginal tax bracket for Federal taxes, you’d multiply $15,000 by 24% to arrive at the cost of the conversion: $3,600.
In both cases, you’d be moving the same number of shares to Roth status, but in the second scenario, the cost to do so would be $2,400 less than in the first scenario — purely because the value of shares you have decreased.
When the shares recover to their previous highs, you’ll have already moved them to your Roth IRA and can enjoy years of tax-free compounding.
Roth conversions are useful — but beware
Roth conversions during market downturns can make a lot of sense, especially because you’ll see huge tax benefits when markets recover and account values begin to rise again. Still, you’ll need to keep in mind that Roth conversions cost money — and sometimes quite a lot of money — so be prepared to pay any associated taxes that arise after the conversion.
Nothing beats strong tax strategies when executed properly. If you’re having trouble determining your total income for the year or the topic of Roth conversions still seems vague to you, be sure to visit a qualified Certified Public Accountant (CPA) or Certified Financial Planner (CFP) practitioner who can guide you through the process.
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