Is a Discounted Roth Conversion Right for You?

By Published On: July 14, 2022Categories: Tax Management, Wealth Building4 min read

While markets are on the rise, it’s easy to forget that drastic drops can happen. But these days, the reality of market downturns is top of mind for investors. And for many tax-minded folks, thisbear market is the opportunity you’ve been waiting for to convert your traditional tax-deferred retirement account into a tax-free Roth IRA.

Here’s the thought process: Your IRA – like most investment accounts today – has taken a hit.The account value is lower, but you’re still holding the same number of shares. Converting the same dollar amount during a stock market pullback means you are able to convert more shares at depressed prices from a traditional IRA to Roth IRA. You only pay taxes on the amount that was converted in the year of conversion.  And in a market recovery, you pay no taxes on the reflated value of those shares. In fact, you will not pay taxes again on those converted shares.

But is this the right move for everyone? Not necessarily. Before you rush to convert your traditional IRA, here are some key factors to consider and help you decide if a “discounted” Roth IRA conversion is right for you.

Pay Now or Pay Later?

As with most financial planning strategies, there is no one-size-fits-all approach. Choosing between paying taxes on your IRA today and paying in retirement falls in that category. It depends on your current tax bracket and your expected future tax rate.

We are currently in a low tax rate environment. However, Congress has the power to change thetax laws anytime they want.  If you believe tax rates might go higher in the future, implementing a Roth conversion before Congress changes the tax laws might be a good tax savings strategy.

For high earners, it could make more sense to make traditional contributions now that help lower your tax liability. For those who expect to be in a higher tax bracket when you retire, making Roth contributions now may avoid more taxes in the future. Knowing where you stand and having a financial plan in place can help you determine if a Roth conversion makes sense for your particular situation.

How Is Your Cash Flow?

When a bear market coincides with inflation, cash flow can play an important role in yourdecision to convert your IRA. For most investors, this change will result in a tax bill and the best way to pay these taxes is with cash. But, given the current inflation levels, dipping into your savings might not be ideal.

Before choosing a Roth IRA conversion, speak with your advisor about your estimated tax liability and make sure you have the liquidity to pay these taxes upfront. Another alternative is to increase your tax withholdings throughout the year to cover the additional tax due.

Is Time on Your Side?

Historically speaking, current tax rates are still low. This means that converting at today’s rates could allow you to pay less than you would at a later date. But, depending on your expected retirement date, you may not have time for your funds to grow tax-free when the market bounces back.

In addition, Roth conversion rules state that you must wait five years to make withdrawals from your Roth. If you’re near retirement, you may not be able to wait five years to take money from your account – and this means that the 10% penalty could outweigh the tax benefit of your conversion.

How About an In-Between?

You’ve heard of dollar-cost-averaging and why market downturns are a great time to use this strategy. But have you heard of conversion cost-averaging? This can be a good technique for volatile market conditions because it spreads your conversion throughout the year and avoidstrying to time the market. It also allows you to adjust your conversion amount as needed, in caseunexpected events put you in a different tax bracket.

It’s also important to remember that Roth conversions are not an all-or-nothing deal. Since the IRS treats Roth conversions as a taxable event at your ordinary income marginal tax rates, it could make sense to convert a portion of your IRA to minimize your tax liability. Higher income levels also impact future Medicare cost surcharges for those 65 and older.  By discussing with your advisor, you can make projections and determine how a conversion would affect your AGI.

Convert with Caution

In the face of this bear market and economic instability, investors should carefully weigh the pros and cons of a Roth conversion. By evaluating your expected retirement date along with your current and expected future tax rates, you can make an informed decision on your retirement savings. If you’re interested in learning more and discovering if a Roth conversion represents a tax advantage for you, please reach out to schedule a call with your advisor.

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