The down market could make it a good time to convert a traditional IRA to a Roth
Thursday, May 19, 2022
I have a stock app on my phone. Yeah, that's it above, with all those ugly, jagged red lines.
I'm smart enough not to get alerts, but now and then when I check other news, I see it. Like today, which got me thinking it's time to delete this piece of electronic info, at least for a while.
But while I'm not enjoying the prospect of delaying the start of my golden years, the declining stock market is good news for some retirement account owners.
If they have traditional IRAs, the current down market could be a good time for them — you? — to convert them to Roth IRAs.
Why you should consider converting now: Since traditional IRAs are funded with tax-deferred dollars, when you move the money into a Roth IRA, you must pay tax on those amounts. By doing so when the value of your traditional IRA is lower, you'll face a smaller conversion tax bill.
Then when the market rebounds (and I put the stock app back on my phone), the gain on your converted Roth account will be tax-free when you ultimately withdraw the funds.
The Tax Cuts and Jobs Act of 2017 (TCJA) adds to the incentive to convert to a Roth now.
That tax reform law reduced individual income tax rates and broadened the income brackets, but only through 2025. Congress and whoever is in the White House must agree to extend them beyond that expiration date. While politicians usually are loath to raise taxes, it does happen.
Plus, we can't be sure what our personal tax situations will be like in the next few years. Now lower rates might make it an opportune time to take tax advantage of a traditional IRA conversion.
Finally, as for the tax here-and-now, a lot of folks have taken an income hit due to the COVID-19 pandemic's economic fallout. Their ordinary salaried or self-employment income is lower than usual. So is the value of their non-retirement accounts.
This income drop could put them in an even lower tax bracket, which would also help reduce any Roth IRA conversion tax liability.
Carefully consider conversion tax matters: The main reason to shift your traditional, tax-deferred, IRA to a Roth IRA is to get the advantage in retirement of tax-free account withdrawals.
But you need to also look at the tax implications the conversion will create.
The main one, obviously, is the tax bill it will produce. The traditional IRA amount you convert counts as taxable income at ordinary tax rates. Even when your IRA's value is lower because of market fluctuations and your overall income means a relatively low tax rate, you'll still have to hand over money to Uncle Sam.
Can you cover your Roth conversion tax bill with other funds? Or will you have to use some of your traditional IRA money or other investments to pay it?
If you have to use the IRA funds, that will decrease the amount going into Roth. That could offset much of the benefit of making the remaining amount tax-free.
Since there's no law requiring a conversion be all the money in your traditional IRA, consider reducing your conversion tax bite by making a partial conversion. You can spread out your conversion over several tax years to reduce each one's tax consequences.
Also, if you're younger than 59½ and use your retirement account funds, you could face an additional 10 percent tax penalty.
The cost of other assets sold: Selling other assets to cover the IRA conversion bill also can create tax concerns.
First, selling in a down market likely will mean you'll take a capital loss. Sometimes that is a wise tax move, for example, to offset any capital gains or some ordinary income.
But it's also possible, even in a down market, that the assets you sell to cover your Roth conversion taxes, even at lower prices than you'd like, could produce capital gains, depending on when you bought and how long you held the asset. In this case, that's an added tax bill, even at the generally lower long-term capital gains rates.
Also, you'll be cutting into your overall investment holdings. That gives you less to use now, which could be needed if the economic slump drags on for a while. It also leaves you with a smaller investment pool to grow when the market recovers. (It will recover. Right?)
Finally, don't forget about your other taxes. Any income increases from the IRA conversion and/or other assets sold to pay the tax could be so much that it disqualifies you for some earnings-limited tax breaks you otherwise might have been able to claim.
Know other Roth limits: You also need to be aware of Roth IRA limits. When your income exceeds a certain amount, the tax law prohibits you from making a full or any contribution to a Roth individual retirement arrangement.
So, if you're still working and want to keep adding to your retirement plan, be aware that once it's converted to a Roth version, your earnings might lock you out of putting as much as you want or even any money into it.
For the 2022 tax year, a single filer making $129,000 to $144,000 and a married jointly filing couple earning $204,000 to $214,000 face limits on Roth contributions. When their incomes exceed their top amounts, they can't contribute at all.
And note that now there are no Roth do-overs. Thanks to the TCJA, once you convert your traditional IRA money to a Roth retirement account, it's there forever. You no longer can recharacterize your conversion.
Overall tax picture required: Yeah, I know. It looks like I'm arguing against a Roth conversion. Not necessarily.
I am, however, arguing for knowing how the move fits into your current (and future, as far as you can comfortably prognosticate) financial and tax circumstances. You need to run the various retirement and tax scenario numbers to make sure the longer-term benefits of converting a traditional IRA to a Roth are worthwhile.
And you need to run those numbers with someone who's an expert in taxes in general and retirement vehicles effects on your federal tax bill.
The issues addressed here are general highlights. Every person's situation is different, and there are some exceptions that could apply.
To avoid unwanted and significant tax consequences in converting your IRA, talk with a tax advisor before making any moves.
You also might find these items of interest:
- More retirement, and tax, changes ahead under W&M approved SECURE Act 2.0
- Retirement threats: Older Americans' growing debt, taxes on Social Security benefits
- Saver's Credit already offers an added nest egg tax break & there's talk of enhancing it
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