What is a Roth IRA Conversion?
To start, remember that a traditional individual retirement account (IRA) is funded with pretax dollars. A Roth IRA is funded with after-tax dollars. A Roth IRA conversion transfers retirement funds from that traditional IRA to a Roth IRA to take advantage of tax-free investment growth in that type of retirement account. When you convert the funds, you owe tax on the money you convert. One way to lessen the tax burden is by making the switch when your IRA’s value has dropped due to a market downturn. If you have been considering a Roth conversion, now may be the time to get serious.
Properly timed Roth conversions can dramatically increase your retirement income security and improve your overall long-term financial health. The current stock market downturn creates a huge opportunity to do Roth conversions at a relatively low tax cost.
Why Consider a Roth IRA Conversion?
You’ll owe taxes on any converted funds the year you make a conversion, and the tax burden could be substantial. Still, there are several scenarios in which a Roth IRA conversion could pay off. These include if you:
- Expect to be in a higher tax bracket in retirement. In this case, it can make financial sense to get the taxes paid now. You’d pay them at your current, lower tax bracket rate.
- Want to leave a tax-free inheritance to your heirs. Roth IRAs have no Required Minimum Distribution (RMD) during the account owner’s lifetime, meaning you can watch your money grow tax-free for longer without being forced to draw down the balance. You can leave the remainder to your heirs. The heirs will have to take RMDs, but they won’t owe federal income tax on withdrawals if the account has been open for at least five years.
- Want better tax diversification. Having some retirement assets that you can draw on tax-free can help you better manage your tax situation every year.
- Have income that is lower than usual this year. A lower-than-usual income year can help lessen the tax hit of a Roth IRA conversion. If the pandemic took a toll on your paycheck, or your business is having a poor year, those will reduce the tax cost of a conversion.
- Have more itemized deductions. A Roth IRA conversion generates ordinary income, which you can offset with itemized deductions. If you have more itemized deductions than usual – and therefore a lower taxable income – it could be an excellent time to consider a conversion.
Let’s Look at a Scenario:
The stock market has dropped; your traditional IRA’s value has dropped. You’ll owe tax on any funds you convert, so the market downturn will reduce the tax.
For example, say your traditional IRA was worth $100,000, and it drops to $70,000 when the overall market declines. In this situation, you would be converting just $70,000 instead of the original $100,000 – shaving thousands off your tax bill.
Now suppose that your traditional IRA has lost value, and your income is lower than usual, or you have more itemized deductions (or both). In those cases, it is a particularly good time for a Roth IRA conversion. You’ll pay tax on a smaller converted amount, and your reduced taxable income and/or increased deductions will save you even more money.
Roth IRA Conversion Consequences
In considering a Roth conversion, you will need to understand the tax cost of boosting your income with the Roth conversion. You will also want to make sure you have the cash on hand to cover the tax bill – any IRA funds used to pay tax won’t be part of the conversion.
Beyond the income tax cost of a conversion, it could also increase Medicare costs, cause more of your Social Security to be taxable, and could limit the use of certain income-limited write-offs, such as the student loan interest deduction or the child tax credit. Do some detailed tax planning first to ensure that the potential consequences don’t outweigh the benefits of the conversion. We can help with that tax planning.
Can I Reduce Taxes on a Conversion?
You probably can’t avoid paying taxes on a Roth IRA conversion, but there are ways to lower the tax bill. One way to control tax is to do smaller conversions, spread out over multiple years.
How Much Can You Convert from a Traditional to a Roth IRA?
There is no limit on the amount you can convert from a tax-deferred account, such as a traditional IRA, into your Roth IRA in a single year. Of course, you will owe tax on the converted amount, so it’s essential to weigh the pros and cons before converting any funds.
The Bottom Line
A poor stock market or a poor income year is not good for anyone. That said, Roth conversions are a way to take advantage of the situation. The key to tax-efficient conversions is good tax planning – we can help.
If you want to consider a Roth conversion, give us a call and we can help you understand the benefits and the tax consequences.