Roth IRA Conversions are "On Sale", should you utilize this strategy?
Market volatility can be quite stressful, especially for those who are near retirement or have recently retired. By the same token, market declines can create favorable tax planning opportunities, which include the ability to maximize Roth conversions at a discount. Before deciding to convert a traditional IRA to a Roth IRA, it is important to understand the differences. Both types of IRAs are designed to help you save for retirement while providing a tax advantage, but they do so in different ways. With a traditional IRA since contributions are pre-tax, you pay the tax upon withdrawal. For a Roth IRA, contributions are post-tax, thus future withdrawals are tax-free. Notably, a key benefit of a Roth IRA is that they do not require taking minimum distributions, unlike a traditional IRA in which required minimum distributions are enforced upon obtaining age 72.
While individuals at any income can complete Roth IRA conversions, it does not necessarily mean that doing so will always be the most tax-efficient decision. The tax benefits depend on the individual’s tax rate today, as compared to their expected future tax rate. Typically, this means that it will be advantageous to make contributions to a traditional IRA and reduce taxable income when a person’s marginal tax rate is higher today than it will be when the account enters the distribution phase. Contributions to a Roth IRA or a conversion from a traditional IRA to a Roth IRA are beneficial when the future tax rate is expected to be higher than it is today.
For individuals considering a Roth conversion during depressed or declining markets can effectively convert their traditional IRAs at a discount by reducing their tax liability. This is attributed with the decline in the account value, since as the account value drops, the dollar amount to be converted to a Roth account will represent a larger percentage of the pre-tax account. This results in a larger portion of the future growth of the account being shifted into a Roth IRA without having to move into a higher tax bracket. Ultimately, this allows for a more sizable portion of the account to be converted. For example: an owner of a traditional IRA has an account balance of $250,000. During a market decline, the account balance drops by 20% to $200,000. Let’s say the account owner is in the 22% ordinary income tax bracket. It could be to the owner’s advantage to do a Roth conversion on either the full or a partial amount of the $200,000 balance. The differences in tax liability can be quite sizable. In this example, the tax liability decreased by $11,000 due to the 20% decline in account value. It is important to utilize market downturns as they can be incredible opportunities to pay reduced taxes today for future qualified tax-free distributions. Although, the benefits depend on how funds are sourced to pay the conversion tax. When it comes to paying the tax liability, it is preferred to use cash from outside sources instead of using funds within the retirement account. Essentially, this will allow a larger balance of the tax-free Roth account to participate in the market recovery.
Notably, for Roth conversions there is a 5-year waiting period after completing the conversion to access the conversion principal tax-free. Roth conversions do not have to be done on an all-or-non-basis, rather traditional IRA owners can choose to convert only a portion of the account. For instance, if you have a traditional IRA worth $750,000, you could choose to convert the full $750,000, $500,000 or only $50,000 or any amount that does not exceed the account balance. It is wise to spread the potential taxes related to the conversion over multiple years instead of getting hit with the entire bill in one year. Not to mention this will also keep you from potentially entering a higher tax bracket.
From a tax perspective, ordinary income rates are still relatively low, historically speaking, so now is as good of a time as any to convert from a traditional IRA to a Roth IRA. Would converting from a traditional IRA to a Roth IRA be a smart move for you? We welcome the opportunity to discuss, review your financial situation and develop a plan that best aligns with you.