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Lane Keeter, CPA

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

Now May Be the Time to Convert Your IRA to a Roth

Under the right circumstances, it can be a smart long-term move from a financial planning perspective to hold retirement funds in a Roth IRA rather than in a traditional IRA. 

The advantages of doing so include never having to pay income tax on the earnings and growth of the Roth account even upon withdrawal, unlike a traditional IRA where distributions are generally fully taxable. 

Another advantage is that, unlike traditional IRAs which upon reaching age 72 you MUST take what are called required minimum distributions (or RMD) over your life expectancy, there is no RMD requirement for a Roth. This means if you want, you can allow the account to continue to earn and grow tax-free for the remainder of your life.

The tax law allows those holding a traditional IRA to convert their IRA to a Roth IRA, and for the reasons stated above, it can be advisable to do so. However, people are sometimes reluctant to do a conversion, even if in the long-run it financially may make sense, due to the price tag that a conversion brings. That price tag is the payment of income tax on the value of the IRA so converted.

But lately, that price tag may very well be significantly discounted for you. This is because of the significant decline in the stock market that has caused much lower stock valuations generally across the board, and of course, the consequent decline in value of many mutual funds, which so many IRA accounts may hold. 

For instance, the Dow Jones Industrial Average (DJIA) hit its all-time high on January 5, 2022 when it hit a whopping 36,952.65 points. As of this writing, the DJIA stands at 29,888.78, a drop of just under 20% since the peak.

That's a tough pill to swallow to be sure for most investors. But if you are holding a traditional IRA, and have been (or perhaps should be) considering a conversion to a Roth IRA, therein lies a silver lining. The lower value now means lower taxes imposed on conversion, and more tax-free appreciation in the future when the market improves, which historically at least inevitably happens in time.

Of course, it's anyone's guess as to whether we have yet to hit the bottom, making now the absolute best time to pull the conversion trigger. Not even Warren Buffett has that kind of crystal ball. Trying to ideally time the market rarely ever works, so sometimes you just have to take your best shot and then settle in for the long haul.

When considering a conversion, the key really is what you think your present and future tax rates will be. If in the future when you need retirement funds you expect your tax rate will be about the same or even higher than they are now, converting to a Roth IRA may make financial sense. If you think your retirement age rates will be lower, the tax-free nature of Roth distributions is less beneficial. And of course, we have no idea what future Congresses/Administrations will do with tax rates (again, that crystal ball thing), although with current rates being historically pretty low, it seems a good bet they might be raised in the future.

There are some other important things to note in the conversion conversation. 

For one, you don't have to convert all of your traditional IRA assets at once. You can always do so a bit at a time to level out the tax hit and/or to leverage against the possibility that stock values may still go lower.

Also, once upon a time a conversion could be "undone" for a period of time if circumstances changed causing you to change your mind. That is no longer an option under current law, so once converted, you can't go back.

Another consideration is that any tax provisions that are affected by the level of your Adjusted Gross Income (AGI) will be affected by the conversion since it raises AGI. So, for example, if you itemize deductions and have medical expenses, it could lower the medical expense deduction, further increasing tax. 

And while those on Medicare or receiving Social Security benefits are not as likely to do a conversion, if they did, the resulting AGI increase could cause higher Medicare premiums and/or a higher amount of their Social Security benefits to be subject to income tax, since both of those are tied to modified AGI levels.

On a final note, ideally you won't have to tap into the IRA funds for the taxes you pay on the conversion, but can pay them from another source. The more you can leave the Roth IRA intact, the more you leave invested to grow tax-free. 

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