Perhaps you have been watching your portfolio value drop in value due to the markets and feel unsettled. If this could be you, there might be an opportunity to make lemonade out of lemons! One strategy you could explore is doing a Roth conversion. This refers to moving assets from a traditional IRA to a Roth IRA. The conversion generates tax on the amount converted. Now could be a good time to do a conversion because you may be paying tax on a lower asset value due to investment losses in the IRA. If certain parameters are adhered to, any money moved to the Roth IRA generates no future tax liabilities. All the growth in the Roth is potentially tax-free when withdrawn!
If you are considering doing a conversion, it is important to determine the taxes involved. If you feel you are going to be in a lower tax bracket once you withdraw the money (such as in retirement), then a vehicle offering a current deduction such as a traditional IRA might be a good choice. If you feel your retirement income might generate a higher tax rate, the Roth IRA may be a better choice.
This could be the case if you have a high pension and Social Security benefit. You do not receive a current tax deduction for money moved to a Roth IRA but you could receive potentially tax-free future income. It’s going to be difficult but a judgment call is needed as to what tax rates are going to be down the road. One compromise is to convert just enough of your traditional IRA to get to the top of your existing tax bracket. To do this a tax projection for the year is helpful.
If you have the same custodian for both your traditional IRA and Roth IRA, you can generally transfer shares from one account to the other. With a lower share price for your investments, you can transfer more shares. More shares in the Roth IRA may result in more tax-free growth if share prices rise over time. Caution though, share prices can drop. There is no guarantee any investment will grow. Additionally, it is generally not a good idea to take the taxes to pay for the conversion from the IRA since this would generate additional taxable income. Using existing cash on hand to pay the tax is usually the most tax-efficient strategy.
We mentioned that there were rules for tax-free distributions from Roth IRAs. For conversions, you can withdraw the equivalent of the converted amount at any time. If you withdraw additional amounts such as earnings there may be a 10% penalty if the money is taken before a five year holding timeframe and, unless an exception applies, you are under age 59 ½. For conversions, the holding period is considered to have begun January 1st of the year you did each conversion.
One final benefit for the Roth is the more favorable required minimum distribution rules (RMDs). The tax regulations for traditional IRAs don’t let the tax deferral continue forever. At certain ages the rules force the account owner to take an RMD. However, the original owner of a Roth IRA isn’t required to take any funds from the account. If a spouse inherits the account and elects to treat the account as their own, the same is true. Non-spousal beneficiaries do have to take distributions, which are generally not taxable.
Given the benefits of a Roth IRA, it is worth considering a conversion. You may have a similar option with your 401(k) – there may a Roth 401(k) as a conversion option. Putting assets with the potential for tax-free long-term growth into the Roth IRA can make a lot of sense. As there are quite a few considerations involved, we would recommend discussing the pros and cons with a certified financial planner.
