Is now a good time to do a Roth Conversion?
by Jake Preston
Periods of losses in the market are an inevitable result of investing. While certainly not enjoyable, downturns present planning opportunities that might be less compelling during a bull market. One such opportunity is a Roth conversion.
Roth IRAs are often referred to as the best retirement plans to own due to their tax-free growth. However, income limits ($144,000 for single filers, $214,000 for joint filers in 2022) prevent high earners from participating and a yearly maximum contribution of $6,000 ($7,000 for those over age 50) generally prevents Roth IRAs from accumulating large balances.
That said, one way for high earners to access this tax-free growth and to avoid contribution limits is through a Roth conversion. A Roth conversion involves moving assets from a traditional IRA to a Roth IRA and paying income tax on the amount transferred.
Before moving ahead, it’s important to review the primary differences between traditional IRAs and Roth IRAs.
Contributions to a traditional IRA are often tax deductible and the account grows tax-deferred over time; however, withdrawals beginning at age 59 1/2 and older are fully taxable as ordinary income. Taxable withdrawals are required beginning at age 72.
A Roth IRA on the other hand is funded through after-tax contributions. The account grows over time and withdrawals at age 59 1/2 and older can be tax-free if certain conditions are met. Another important difference: unlike traditional IRAs, Roth IRA holders are not forced to take required withdrawals beginning at age 72.
What factors are important to consider before completing a Roth conversion?
Tax Rate at Conversion v. Tax Rate at Withdrawal
Because income tax is paid during the year of conversion, Roth conversions make the most sense during lower-tax-rate years.
For example, let’s say a recent retiree (age 65) expects to be in the 12% tax bracket this year as he will be relying on income from his taxable brokerage account (withdrawals taxed at lower, capital gains rates) and part-time work. However, in 10 years he will be forced to make substantial withdrawals from his traditional IRA which will likely push him into the 22% or 24% tax bracket. Not only that, but there is also a high likelihood that a portion of his Social Security benefits will be taxed as ordinary income as well. In this case, a sizeable Roth conversion would make sense for two reasons: (1) he will pay tax on the conversion at 12% rather than at 22% or 24% later and (2) the conversion will decrease the size of his traditional IRA, thus lowering the amount he will be required to withdraw at age 72.
If an investor expects to be in a lower tax bracket in the future, a Roth conversion likely wouldn’t be prudent as it would force the payment of tax at a higher rate than for a distribution later from a traditional IRA.
* A note for those age 72 or older: the required withdrawals from a traditional IRA must be satisfied before completing a Roth conversion.
Current Stock Prices
Another factor to consider before making a Roth conversion is the current market condition and stock prices.
The lower the stock prices, the lower the tax bill on a Roth conversion. Assuming prices eventually recover and grow, an investor is making a Roth conversion “on sale.”
How is this the case? As the total value of the traditional IRA drops due to the market downturn, the amount converted to a Roth IRA will represent a larger percentage of the pre-tax account, resulting in a larger portion of the (potential) future growth being shifted into an account that allows for tax-free growth.
The bottom line: market downturns present a unique and compelling time to complete a Roth conversion. A bear market isn’t so bad after all!
Paying the Tax Bill Out-of-Pocket
A final item to consider before completing a Roth conversion is the ability to pay the tax bill with funds outside of the account being converted.
Because taxes on the amount converted will be due in the year of conversion, the investor may need to tap into a savings account to satisfy the tax. Generally, it is not a good idea to pay the tax with IRA assets as it shrinks the amount that can grow tax-free into the future.
Is a Roth conversion right for you?
While it can be painful to watch investment account balances shrink because of a downturn, always keep in mind that challenging market conditions present unique planning opportunities not otherwise available or compelling during periods of growth.
It is important to choose a financial advisor who is both competent in all areas of financial planning (tax planning, investment management, estate planning, etc.) and knowledgeable about your unique situation.
Want to know if a Roth conversion is a good option for you? Give us a call to discuss your situation! We’ve had a number of these conversations recently and are always happy to discuss options to help you meet your financial goals.
Jake Preston, CFP® is a Christian financial planner in Roanoke, VA specializing in comprehensive financial planning and faith-based investing. In addition to serving clients, Jake is the Lead Financial Planner at Beacon Wealth Consultants where he oversees all aspects of financial planning for the company.