During all market cycles, it’s wise for investors to consider Roth IRA conversions for their underperforming assets. But bear markets may warrant extra consideration.
The reason is simple: These assets may have a lower valuation during the downturn, which means a smaller tax bill from the conversion. Additionally, there’s the potential prospect of tax-free growth in the future, if markets rise again and the value of your investment increases.
However, Roth conversions are better suited to some investors more than others. Reach out to us so we can assess whether you may benefit from this strategy.
How a Roth IRA conversion works
A conversion moves assets from your traditional IRA or 401(k) plan to a Roth IRA. While you'll pay taxes on the pre-tax retirement assets the first year you convert, future earnings on your money will be tax free. When you have met certain requirements, withdrawals will be tax free, too.
Benefits and tradeoffs of Roth conversions
- No conversion limits: There are no limits on the amount you can convert from a traditional IRA to a Roth IRA.
- Future flexibility with conversion assets: You can access your conversion assets (excluding earnings) after five years without penalty for any reason.
- Potential for tax-free growth: You may be able to accumulate a significant amount of tax-free earnings.
- Tax-free withdrawals: Qualifying distributions (withdrawals) are income tax-free to you and your beneficiaries.
- Upfront tax payments: You’ll need to have a lump sum of money readily available to pay the taxes owed. These taxes are due for the same calendar year you make the conversion.
- Potential for assets to decline in value: It’s possible the value of an IRA converted to a Roth IRA may continue to decline, making it worth less than the taxable reported market value at conversion.
- Your decision is not reversible: You will not be able to recharacterize or “undo” the conversion.
You cannot access the assets for 5 years: Be aware that if you withdraw converted amounts before 5 years and are under 59.5, you might have to pay a 10% penalty to the IRS.
Roth IRAs and tax diversification benefits
As you consider the benefits of a Roth IRA conversion, keep in mind that diversifying your portfolio between tax-free, deferred-tax, and taxable accounts can pay off in the long run.
In fact, many investors tend to be overweighted in investments that will be taxed in retirement — and Roth IRAs can act as helpful counterbalance to deferred-tax accounts like 401(k) plans and traditional IRAs.
What kind of investor may benefit from a Roth IRA conversion?
Scenario 1: Investors who are far from retirement
In most cases, an ideal investor for conversion is one who is:
- Far from retirement (5+ years)
- Able to leave the money untouched for at least 5 years
- In a lower tax bracket than what they expect to be in their retirement years
- Equipped to pay the subsequent taxes from a Roth conversion (ideally with funds outside of a traditional IRA or employer retirement account)
Scenario 2: Investors who are near retirement
While Roth conversions will generally be more beneficial for those with longer time horizons, there are exceptions. Consider these scenarios:
- Special occupational circumstances: If your income for the current year is lower than when you’ll be in retirement due to a special situation, perhaps as a result of unpaid sabbatical or other unpaid leave
- Estate planning purposes: A pre-tax conversion enables you to pass your Roth IRA tax-free to heirs.
- Spousal considerations: Consider a pre-tax conversion while you and your spouse are still filing taxes as a married couple. Upon the death of a spouse, the surviving spouse who is the new owner of the Roth IRA may be able to avoid moving into a higher tax bracket when their status changes from joint to single because Roth withdrawals are income tax free.
Scenario 3: Investors who benefit from 2018 tax cut income brackets
The 2018 tax cuts are expected to sunset in the coming years. Lower income brackets available until 2025 may make a conversion a more attractive opportunity for some investors now.
Is an after-tax conversion a better strategy for you?
While a taxable Roth conversion can be advantageous, it’s not the ideal strategy for everyone. If you have maxed out pre-tax 401(k) contributions and/or earned too much income to contribute to a Roth IRA, you may still be able to make after-tax contributions to your 401(k). This can present a special opportunity, known as a backdoor Roth IRA, for a tax-free conversion, since after-tax contributions are not subject to income tax when converted to a Roth IRA.
Does a conversion make sense for your situation?
We can offer a personalized recommendation on whether a Roth conversion is the right strategy for you, including help with:
- Setting up and transferring funds to a Roth IRA
- Strategies to mitigate the taxes you owe on the money you plan to convert
- Tax-efficient withdrawal strategies for your retirement income
Reach out to us if you’d like to discuss what opportunities may be the best for your financial goals.