We’re all looking for glimmers of hope in the market right now as we are inundated with negative headlines and buzzwords. Indeed, the stock market is out of our control, so let’s focus on what we can control: how we react.
Beyond just staying invested, we can use the perfect storm of a temporary market downturn and low tax rates to explore the possibility of Roth conversions.
Let’s take a step back. What is a Roth conversion?
Basically, it’s voluntarily paying the taxes on some of your pre-tax retirement dollars now for the benefit of having them tax-free in the future. It may go against your grain to pay taxes when you don’t have to, but they’re going to get paid eventually — so why not pay less?
Tax policy is far from set in stone, but the current tax brackets (put in place from the Tax Cuts and Jobs Act [TCJA] of 2017) are in effect through 2025. After that, they are set to return to the higher 2017 rates.
If your estimated retirement income and future tax hikes result in a higher bracket down the road, it might make sense to pull the trigger on a Roth conversion. Even if your projected retirement tax bracket is similar to today’s, a conversion may be considered for future tax diversification. Also, you don’t have to take required minimum distributions from a Roth IRA.
Now this is where the market pullback comes in.
You see, your 100 shares of XYZ fund are probably worth a lot less today than they were in January. (If not, good for you!) Whereas at $50 a share you could convert $50,000 to Roth by transferring 100 shares, now at, say, $40 a share, you could convert 125 shares…and still only pay taxes on $50,000. When the market eventually recovers, the appreciation on all those shares will be accumulating tax-free in the Roth.
The true value of a Roth conversion comes down to math and the difference in assumed tax brackets. Say, for example, you convert at a tax rate of 22% today. The conversion amount will grow tax-free in the Roth.
Assuming the same growth rate in the Traditional IRA and the same 22% tax rate at withdrawal, it’s a complete wash regardless of the year of distribution. But if that future tax rate is, say, 25%, your after-tax spendingable dollars in the IRA would be less than the Roth, even though you deferred the taxes for longer.
Remember, the amount on your Roth statement is yours to keep. Meanwhile, the IRS owns a hefty portion of your pre-tax IRA balance, and they can decide to increase their share at any time.
Before doing a Roth conversion, remember that you will owe federal and state taxes on the conversion amount. This does not incur a penalty. However, you may be subject to a 10% tax penalty if you are under age 59½ and use funds in the IRA to pay the tax on the conversion.
For that reason, it makes sense to pay the taxes with separate, after-tax dollars (money in a brokerage or savings account). Also, be aware that taking a distribution from a Roth IRA within five years of the conversion may create a penalty tax in certain circumstances.
Because of its complex nature, you should execute this strategy in consultation with your financial planner, tax professional, or both.
There’s a lot to consider, after all. Medicare, Social Security and capital gains all play a role in total tax liability in retirement. A death of a spouse could leave the survivor as a single filer in a higher tax bracket. If your assets pass to other heirs, it may be beneficial to consider their future tax rates.
A Roth conversion can benefit many investors, and not just those closing on retirement: I did one last year at age 33. It could just turn this uncomfortable market downturn into an opportunity to lower your future tax bill and strengthen your financial plan.
Tyson Sprick is a CERTIFIED FINANCIAL PLANNER professional and a member of Financial Planning Association of Greater Kansas City. He is a partner at Evolution Advisors and he offers securities through Equitable Advisors, LLC.
This story was originally published July 13, 2022 5:00 AM.