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Robert Bloink and William H. Byrnes

Retirement Planning > Saving for Retirement > IRAs

Roth IRA Conversions: Is Now a Good Time?

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What You Need to Know

  • Clients can minimize the tax on the conversion by executing it when their account value is down.
  • Income tax rate reductions enacted in 2017 are set to expire in 2025.
  • But clients must keep the money in the Roth for at least five years after the conversion.

The current stock market downturn has investors struggling across the board. Many advisors have been swamped with calls from clients asking for advice about tax-smart moves to make the most of the turmoil.

While it may seem that the situation looks dismal from every angle, there are tax-efficient moves that can be made to make the most of a bad situation. Clients who are interested in creating a source of tax-free income for retirement may wish to consider converting a traditional IRA to a Roth account while the market is down in order to minimize the tax liability generated by a Roth conversion.

Basics of Timing the Roth Conversion

Roth IRAs are funded with after-tax dollars. Because the client pays taxes on the funds today, those funds (and, in most cases, any earnings) can be withdrawn tax-free when the client eventually reaches retirement age.

The primary reason to consider moving traditional IRA funds into a Roth IRA in a market downturn involves tax savings when compared to strong market conditions. When a client executes a Roth conversion, taxes are due on the value of the amount converted (at current ordinary income tax rates) in the year of conversion. 

If the value of the IRA investments has declined (which is the situation most clients are in right now), the client can convert the IRA assets at that lower value and benefit from a correspondingly lower tax liability. When the market rebounds, the gain on the converted Roth assets will be tax-free to the client. 

Under current law, conversions may be even more attractive to certain clients because income tax rates were reduced by the 2017 tax reform legislation. Those lower tax rates are temporary and set to expire after 2025. In fact, many clients might have been considering a Roth conversion in order to take advantage of the lower rates. 

Clients who have (or anticipate) reduced income levels in 2022 because of reduced asset values might also find themselves in even lower income tax brackets. A lower income tax bracket obviously also reduces the overall tax cost of the Roth conversion.

A Roth conversion also allows those who exceed the income thresholds to contribute to a Roth directly — $214,000 for a couple or $144,000 for an individual — to fund a Roth.

Is a Roth Conversion the Right Move?

There are many additional considerations when determining whether now is the time to execute a Roth conversion.

The growth on the converted amount is not taxed when the client withdraws the funds during retirement. However, the client will have to pay tax on the 2022 conversion, which will be due by April 15, 2023. Clients therefore must consider whether they anticipate having cash on hand to cover the tax bill given the possibility of a protracted economic downturn. Selling investments in a down market to cover the tax bill might be counterproductive, locking in some of the investment losses for the client.

Additionally, clients can no longer recharacterize (or undo) the conversion. Under pre-2018 law, clients could use the benefit of hindsight and undo the conversion if the market did not perform as expected. The 2017 tax reform eliminated this benefit.

Investors must also wait five years before they can withdraw the amounts that have been converted (regardless of the client’s age) — meaning that the funds converted will be locked into the Roth for at least five years, or the client will incur a 10% penalty on the amounts withdrawn. That five-year clock starts running on Jan. 1 of the year the client executes the Roth conversion.

Conclusion

There are many benefits to funding a Roth IRA. Funding a Roth now does create a source of tax-free income in retirement and Roths are also exempt from the IRS’ lifetime minimum distribution rules. Still, it’s important to examine the client’s situation as a whole before making any moves in today’s market. 


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