If you’ve been thinking about converting a traditional IRA to a Roth IRA, here’s good news: This year’s market turmoil may be giving you a golden opportunity to do it.
That’s because the stocks and bonds in your traditional IRA are probably worth a lot less than they were a year ago, or even in January, so the amount of tax you would have to pay on the less conversion too.
“Lower markets provide opportunities to do Roth conversions with a lower tax impact,” Mark Wilson, president of Mile Wealth Management in Irvine, Calif., tells me. “I would be looking at these opportunities.”
Call it “mark market bonus”.
Roth IRAs are retirement accounts on which you have already paid all the tax. You contribute with after-tax dollars, but after that you (in theory) don’t have to pay tax again on the money in the account, even when you take it out.
The reason I say “theoretically” is because I have a constant fear that Congress, facing budget deficits in the coming years, might suddenly redefine Roths as “loopholes” or ” handouts” to the rich (you know the drill. ), and start taxing them twice.
In contrast, traditional IRAs are ones where you make pre-tax dollars — you can deduct the contribution on your federal and state tax return — but where you’ll have to pay taxes later, when you withdraw the t -money.
There is a lively and ongoing debate about whether IRAs or traditional Wagons are “better,” and why. Some of it really depends on your circumstances.
Soaring inflation over the past year has strengthened, somewhat, the arguments in favor of Roths. That’s because it will tax more retirees on their Social Security benefits, through a phenomenon known as “bracket shifting”: Your nominal income rises, but the thresholds and tax brackets do not.
“The benefits of a Roth IRA really shine because you can withdraw money tax-free on retirement income unlike [a traditional] IRA,” says Jon Ulin, CEO of Ulin & Co. Wealth Management in Boca Raton, Fla. “Furthermore, qualified Roth distributions are not even reported on your tax return and have no effect on the taxability of Social Security benefits.”
Those who say I’m too cynical about Congress and Roth IRAs, and insist that Congress would never tax the money twice, should remember that Social Security benefits were tax-free because you already made your contributions own with a dollar after tax. In other words, you have already paid tax on the money. But in the 1980s Congress changed the rules and started taxing benefits as well: Double taxation.
Of course, at the time they said it would only apply to the highest earners: About 10% of pensioners. But here we are and it is now about half. And the percentage is steadily rising every year.
One of the many arguments in favor of traditional IRAs is that they always give you the option to convert them to Roths later. All you have to do is fill out a form with your broker or investment manager, transfer the money into a Roth IRA — and report the transfer amount on your federal tax return as income for the year.
That’s where the market downturn can work in your favor. So far this year the S&P 500 SPX,
and the MSCI AC ACWI World Index,
All of them are down almost 20%. The US bond market is down about 12%. Conversions at these levels avoid some of the tax you would have paid if you did it late last year.
But Wilson cautions that this is not a one-way bet. “I would caution people not to be too aggressive with Roth conversions (especially very large ones),” he says. “ Volatile markets tend to be volatile for a while and the conversion sum may continue to fall in value resulting in taxes on a value that no longer exists. (No more ‘undos’ with Roth conversions.) It’s no fun paying taxes on a $30,000 conversion when the Roth is only worth (say) $25,000.”
As Dennis Nolte, a financial adviser at Seacoast Investment Services in Winter Park, Fla., says, those who made Roth conversions too early are already regretting it. “Roth conversions are now looking positive as the contributions made in January have already sunk in,” he says.
Yes again, you can’t time the deal. If things turn around, sooner or later, the extra savings lost won’t hurt much.