Bear markets are no fun (for anyone). They are stressful and can often cause investors to question even their best laid financial plans. But what we like to focus on in a downturn isn’t all the doom and gloom, but rather how we can take advantage of these down markets to position your portfolio for even better returns in the future. You see, market downturns create some favorable tax planning opportunities, including the ability to strike while the iron is hot on discounted Roth conversions.
WHAT IS A ROTH CONVERSION?
A Roth conversion is essentially a rollover of all or some traditional IRA funds into a Roth IRA for the purpose of reaping the tax benefits of the Roth IRA account. Those benefits include tax-free income in retirement and the absence of Required Minimum Distributions (RMDs). Just note that any converted amounts may not be withdrawn for five years without possibly incurring an early withdrawal 10% penalty.
WHEN DOES A ROTH CONVERSION MAKE SENSE?
While investors of all income levels can complete a Roth conversion, it does not necessarily mean that it is always a good idea from a tax-planning perspective. This is because a conversion is a taxable event, meaning the funds that are rolled over will be taxed now at ordinary income rates.
For a Roth conversion to make sense, it should save you money in the long run. Meaning, will you pay lower taxes overall with a conversion today, or by keeping the funds in a traditional IRA and thus deferring taxes until distributions commence? The optimal strategy for you will depend on variables such as your tax liability now versus in retirement, your income now versus in retirement, and how much tax-deferred income you currently plan to use in retirement, to name a few.
For those who are positioned to benefit from a Roth conversion, down markets are the perfect opportunity to execute them as they can save you thousands in taxes depending on your situation.
WHEN ROTH CONVERSIONS GO ON SALE IN A DOWNTURN
Because the tax is calculated on the value of the funds transferred, converting when the values are depressed is akin to converting at a discount. Essentially, you can choose to transfer more with the same tax liability, or you can choose to transfer less and ultimately save on the taxable event. If you plan to pay the taxes resulting from the conversion with out-of-pocket funds, this can be an opportunity to save on taxes with the reduced value transfer. Once the conversion is complete, you reap the benefits of any future appreciation in the Roth, where future distributions will not be taxable.
WHEN CAN A CONVERSION BE MADE?
Roth conversions can be made any time of year—the beginning of the year, the middle, the end. Many individuals prefer to perform the rollover toward the end of the year when they have a clearer picture of what their tax liability will look like. But the timing decision is ultimately yours.
Some investors choose to conversion-cost average which means they divide a selected annual conversion amount into regular, smaller contributions throughout the year. Others “barbell” their conversions by converting all their funds at the beginning or the end of the year. The latter can allow for adjustments should income levels unexpectedly change throughout the year.
IS THIS ROTH CONVERSION SALE THE RIGHT TAX PLANNING OPPORTUNITY FOR YOU?
The main goal of a Roth conversion in a market downturn is to convert a higher percentage of pre-tax account funds into a Roth account for the same taxable income. So, while bear markets can be tough and challenging for investors, they aren’t all bad. They do present some financially savvy opportunities to build a brighter tomorrow for yourself and your portfolio.