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 Because the client pays taxes on the funds today, those funds (and, in most cases, any earnings) can be withdrawn tax-free when the client eventually reaches retirement age.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