​Bear Scare: Bad Stock Market Might be a Good Time for a Roth IRA Conversion

Ever considered a Roth IRA conversion but didn’t want the hefty tax bill? Well, if there’s any upside to a down market, making that switch now could reduce that tax bite.

But let’s back up and define some terms and walk through the process.

A conversion involves transferring retirement funds from a retirement account — usually an individual retirement account you fund with pretax dollars — to a Roth IRA. You fund your Roth with after-tax dollars.

If you convert your account, you’ll owe taxes. But you can reduce how much you have to pay by switching if your IRA’s value has dropped during a market downturn like the one we’re seeing now.

Why would you want to convert, though? If you think you’ll be in a higher tax bracket when you retire, you’ll save money by paying taxes now instead of later.

Traditional vs. Roth IRAs

The big difference between traditional and Roth IRAs is the timing of the tax advantages. With a traditional IRS, you deduct contributions now and pay taxes on withdrawals later. On the flip side, you don’t receive any up-front tax breaks with a Roth IRA, but qualified distributions are tax-free.

Also, there are no required minimum distributions with a Roth IRA. So, if you don’t need the money, you can leave the account alone, and it’ll grow tax-free. That can be good news for your heirs.

The Five-Year Rule

Another benefit of a Roth IRA is that you can withdraw your contributions at any time, for any reason, with no tax or penalty. The catch is that when it comes to Roth IRA conversions, you have to wait five years to withdraw converted funds to avoid a 10% penalty. The clock starts on Jan. 1 of the year you converted, and a separate five-year period applies to each conversion.

Is a Roth IRA Conversion Right for You?

It’s possible you could owe a lot of taxes on the funds you convert. But it still could be worth it. Especially if you:

• Expect to be in a higher tax bracket in retirement. If that’s the case, it can make financial sense to get the taxes over so you’re paying them now when you’re in a lower tax bracket.
• Want to leave a tax-free inheritance to your heirs. Although your heirs will have to take RMDs, they won’t owe federal income tax on withdrawals if the account has been open for at least five years.
• Want better tax diversification. If most of your retirement assets are in tax-deferred accounts —like traditional IRAs and 401(k)s — you may want some assets you can withdraw tax-free. This can help you manage and personalize your tax brackets and planning every year.
• Have lower income than usual this year – An income drop can help reduce how much you’d have to pay in taxes for a Roth IRA conversion. If the pandemic took a chunk out of your paycheck or your business operated at a loss, you could convert funds to a Roth IRA with less tax impact than during more profitable years.
• Have more itemized deductions – A Roth IRA conversion generates ordinary income, which you can offset with itemized deductions taken on the same tax return. If you have more itemized deductions than usual — and a lower taxable income — it could be a great time to convert to a Roth.

Note: If you have to take an RMD from your traditional IRA in the year you convert, you’ll need to do so before converting.

What Happens When Stocks are Down?

So, let’s say your traditional IRA’s value has dropped. Since you’ll still owe tax on any funds you convert, the stock market downturn could make a conversion more appealing because you’ll pay tax on less money.

For example, say your traditional IRA is worth $100,000, and it drops to $60,000. In this situation, you’re converting just $60,000 instead of the original $100,000. That could cut thousands from your tax bill.

Consequences of Converting to a Roth IRA

First, you’ll want to make sure you have the cash on hand to cover the tax bill.

Also, be aware that an increase in taxable income could bump you into a higher tax bracket. It could also lead to higher Medicare costs, higher Social Security taxes, and the loss of certain write-offs, like student loan interest deduction or the child tax credit.

And finally, under the Tax Cuts and Jobs Act (TCJA) of 2017, you can’t recharacterize converted funds back into a traditional IRA.

How Do You Convert?

If you decide a Roth IRA conversion is right for you, you’ve got several options to switch. These include:

• A direct rollover — You can ask your plan administrator to make the payment directly to your Roth IRA.
• A trustee-to-trustee transfer — Ask the financial institution holding your IRA to make the payment directly to your Roth IRA. If the same financial institution holds both accounts, this is called a “same trustee transfer.”
• A 60-day rollover (indirect rollover) — You receive a distribution from your traditional IRA custodian, and then you deposit the funds into your Roth IRA within 60 days. This is the least secure choice, and you can be subject to tax penalties if you don’t do it right.

No matter which method you use, the IRS will collect the tax you owe when you file your tax return for the year of the conversion. Your IRA custodian will report the conversion as a distribution on Form 1099-R and the Roth contribution on Form 5498.

Can You Avoid Taxes All Together?

That’s pretty unlikely. But there are ways to lower your tax bill. One way is to spread the conversion over multiple years.

You can also max out your tax bracket. For example, let’s say you’re single and earn $142,000 a year, putting you in the 24% tax bracket. The next tax bracket kicks in when your income exceeds $170,050. You could convert up to $28,050 ($170,050 - $142,000) without bumping up a bracket.

How About a Roth IRA Conversion Ladder?

Instead of shifting your money just once, as you would with a standard conversion, you could do a series of conversions over several years. If you do it right, you can withdraw the converted funds without tax or penalty before age 59½.

How Much Can You Convert?

There’s no limit on the amount you can convert from a tax-deferred account into your Roth IRA in one year. But as we’ve noted previously, you’ll still owe taxes. So, make sure you’ve weighed the pros and cons.

Expiring Tax Rates

Here’s another reason to consider a Roth IRA conversion: low tax rates and looming tax rate hikes. The current federal income tax rates, ranging from 10% to 37%, are set to expire at the end of 2025 if lawmakers don’t extend them, which would reinstate the higher 2017 rates. That means a Roth IRA conversion could save you even more if you’ll be in a substantially higher income tax bracket during retirement.

Questions about converting to a Roth IRA? Let us know.

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