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Lane Keeter, CPA

Partner: Tax Consulting, Estate Planning, and Heber Springs Managing Partner

Converting to a Roth IRA During Market Downturns

Even though the stock market has in large measure rebounded since taking a dive a year and a half or so ago, it hasn't returned to the record highs reached before doing so. This leaves many portfolios still valued below what they were at their peak.

Because of this, for those with investments held in pre-tax retirement accounts, such as traditional IRAs and 401(K) accounts, this may be a good time to consider converting some, or even all, to a Roth IRA, especially if you expect to be in a higher tax bracket in the future.

First, a primer on Roth IRAs (we'll just refer to them as a Roth here on out). A Roth is a type of investment account in which you enjoy tax-free income and growth, as well as make tax-free withdrawals later. Why do they allow this good deal? Mainly because you will have paid income taxes already on the money that you put into a Roth.

There are limits on the annual amount you can contribute to a Roth. Those limits for 2023 are $6,500 if under age 50 or $7,500 if age 50 or older and are adjusted annually for inflation. There are also limits placed on the ability to fund a Roth based on income, meaning not everyone can contribute to them annually because their income is too high. However, there are no such annual or income limits on conversions from pre-tax retirement accounts to a Roth.

There is a cost to converting a pre-tax retirement account to a Roth, that being the payment of income tax on the value of the conversion. This probably leads you to wonder, why would anyone voluntarily incur income tax before they must do so? I'm glad you asked.

One reason is that any FUTURE income or growth in the Roth will be completely tax-free, assuming you hold the Roth for at least five years from the date of the first contribution before making a withdrawal. Because you eventually would have had to pay tax on that future income and growth, your total tax bill could very likely be lower over time than if you had not made the conversion. This is especially true if your tax rates in the future are higher than now, as many think theirs might be.

Another reason to consider a conversion now directly relates to the downturn in the market. History shows that markets always rebound. If your accounts are lower now than say at the end of 2021, the silver lining is that by converting now, you will be paying less tax on the conversion than if your account had never declined in value. When the accounts rebound, which they almost certainly will, that rebounded value will be locked in tax-free.

It's important to note that you don't have to convert your entire pre-tax portfolio in any one year. Some planning may be needed to make sure the conversion doesn't push you into a higher tax bracket for the year than you were expecting. If it will, you may decide to only convert a portion of your pre-tax funds to a Roth now and wait until a future year to consider further conversions. Some advisors refer to converting pre-tax money gradually over time to a Roth as a Roth ladder.

Of course, you may decide that the difference in the tax brackets is not enough to delay and that the extra tax paid will be more than made up by the tax-free growth that could occur by going ahead and converting more now.

One more critical item of note is that with a Roth you can always withdraw your contributions to the account (but not earnings) income tax-free, which makes sense since you have already paid income tax on those funds.

However, before age 59.5, if you are not careful, you could be hit with the 10% early-withdrawal penalty if you withdraw the funds too soon. If under that age, the law requires that you wait at least five years from when the funds were converted to avoid the 10% penalty. Further, the five-year holding period restarts for each conversion, effective January 1 of the conversion year. This issue goes away once reaching age 59.5.

One final advantage of a Roth to know – unlike traditional IRAs and 401(K) accounts, which have minimum distribution requirements once you reach age 73, there is never a requirement to take a distribution from a Roth. You literally can never touch the money if you don't need to, and leave the entire value tax-free to your heirs.

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