While the market may not be a fun time for investors, there are some bright spots and opportunities to be had. Stock market drops like we’ve seen recently might make a Roth IRA conversion more appealing as a strategy for investors.
Should you consider converting a traditional IRA to a Roth during a down market? There are a few things to consider before doing so.
What is a Roth conversion?
Before you embark on a Roth conversion, you need to fully understand what it is. When you have a traditional IRA, those are pre-tax dollars that you’re investing. While money grows tax-free, when you later go to take a withdrawal, every dollar you pull will be taxed.
With a Roth IRA, you are investing post-tax dollars, and when you convert a traditional IRA to a Roth, you pay the full tax during the year that you convert, at ordinary income rates. Then, the dollars that you’ve converted will grow tax-free for the remainder of the time that they sit within the investment. When you later take money out of a Roth, it’s all tax-free, if you are 59 ½ or older and follow a few rules.
Important information on Roth conversions in a down market
When you start a Roth conversion, you’ll be responsible for paying the tax due on any pre-tax contributions or earnings with the traditional IRA. The benefit here is that if the market has dropped, it’s likely that your IRA value has dropped along with it – so your full value has gone down, and you’ll be paying taxes on the current value (which is lower, due to the market being down). So, in theory, you can convert a larger portion of your IRA in a down market and pay less in taxes than you could in years when the market is up.
What are the pros of a Roth conversion?
Converting from a traditional IRA to a Roth has potential benefits for investors. Because a Roth IRA allows for dollars to grow tax-free, all the growth is also tax-free. There are also no RMDs, or required minimum distributions, on a Roth IRA once you turn 72. With a traditional IRA or 401(k), you have a set minimum you must withdraw each year once you hit RMD age, but Roth IRAs do not adhere to this rule.
Words of caution on Roth conversions
Roth IRA conversions aren’t all benefits though, there are a few things to be aware of. There’s the five-year rule, where you must wait five years after conversion before making a withdrawal, or else you could incur a 10% penalty. Keep in mind that this five-year rule only applies to those younger than 59 ½. After you reach that age, the five-year rule and its penalties no longer apply.
Triggering a Roth conversion may also increase your adjusted gross income (AGI), which could compound other issues, such as Medicare premiums. This may also increase your tax rate.
The best way to help determine if a Roth conversion is the right move for you during the market is to work with a financial advisor and tax professional so you can get feedback on your specific situation.