When the stock market is in a tailspin, and your stomach is tied in knots, it might actually be a great time to convert some (or all) of your Traditional IRA to a ROTH IRA. A market downturn can indeed be an opportune time to do more than simply sit on your hands or bury your head in fear.
Proper timing and strategy could make a big difference in lessening your (eventual) taxes.
What’s the Difference between Traditional and Roth IRAs?
A Roth IRA is funded with dollars that have already been taxed. But, once deposited into your Roth account, these funds can grow indefinitely, free of more taxation – EVER! That’s right. Roth IRAs are tax-free when you withdraw the funds later on, in your retirement years. You’ve already paid Uncle Sam up front.
Traditional IRAs, on the other hand, are funded with pretax dollars, so taxes are still owed. You aren’t responsible for the taxes, however, until you withdraw the funds. That could be decades from now, if you’re young. “Great”, you might say, thinking that putting off taxes is always a good thing! But if you do have decades before retirement, those funds also have decades to grow, and get substantially larger. That’s good for the most part, until it comes time to pay those pesky taxes. And since your tax liability will be based on the amount withdrawn, not deposited, the taxes owed will most likely have grown substantially too. Uncle Sam will eventually collect taxes on those funds, which will include both the original investment and (hopefully) growth.
As the Traditional IRA grows, it “potentially” increases the eventual tax burden, whereas, the Roth IRA grows tax-free!
This can be a really BIG difference!
Another BIG Difference – Required Minimum Distribution
There’s another big difference between these two IRA types. With the Roth IRA there is NO Required Minimum Distribution (RMD). Essentially Uncle Sam doesn’t mind how long you leave the funds to grow, without withdrawing any funds. The IRS has already collected their share (taxes). You can even leave your Roth funds to your beneficiaries if you chose, and never touch it. So your investments can be left to grow and build indefinitely. In contrast, the IRS requires that you start making regular withdrawals (RMDs) from your Traditional IRA no later than age 70 ½ years of age, if you haven’t already done so earlier. Essentially, they want their piece of the pie (taxes) and won’t wait forever to get it!
Why is Timing your Conversion Important?
If your Traditional IRA is invested in stocks or funds that have moved significantly lower, it may be a great time to consider a Roth conversion. This would require you to pay taxes on the amount you convert NOW, rather than waiting until later, when you eventually withdraw the funds. However, you are taxed at the VALUE of the equities or funds at the time of conversion, not on your original investment.
An Example:
Scenario One:
Imagine you bought 100 shares of XYZ Stock a few months ago at $100 per share ($100 x 100 shares = $10,000 value). If you decided to convert the entire lot of 100 shares from a Traditional to a Roth IRA at that time, you would be liable to pay income taxes on $10,000 (value at the time of conversion).
Scenario Two:
Fast forward, and imagine the market takes a nosedive. You held onto those 100 shares of XYZ Stock, but they are now trading at just $60 per share, a 40% loss (though the loss is only on paper if you don’t sell). Those 100 shares are now valued at just $6,000, instead of the original purchase price of $10,000. If you opted to convert (to Roth) those same 100 shares now instead, while these shares are depressed in value, you would be responsible for paying income taxes on the present value, which is now just $6,000. If you are in a 25% tax bracket for example, you will be saving $1,000 ($4,000 x 25%) in tax liability. You have converted exactly the same shares, paying $1,500 in taxes ($6,000 x 25%) in scenario two, compared to $2,500 ($10,000 x 25%) taxes on the same share transfer for scenario one.
If you opted for the second scenario conversion, hopefully, those 100 shares will rebound in the weeks and months going forward, and get back to the original purchase price, and ultimately go higher. And yet you still only paid taxes on the lower value, when the market took a downturn.
So the take away is this:
If you convert funds or equities from Traditional to Roth at a time when their values are deflated, you will pay less taxes, than doing the same conversion at a time when share prices are higher. This also allows them to grow back to that higher value in a completely tax-free vehicle, while you have only had to pay taxes on the lower value.
(Note: If you have been investing in inverse ETFs or the like, they will typically be UP in market downturns, so the logic doesn’t work with those, or any other fund/equity than my be UP during the downturn.)
But remember, a conversion of funds from Traditional to Roth IRA, is a TAXABLE event, so proceed with care and considerable planning. If this is not your forte, be sure to seek advice from an expert before proceeding.
So is a market downturn POTENTIALLY a good time for YOU to do a Roth convertion?
It might be.
Yes, it’s a vague answer, I know.
Because everyone’s tax situation is different, their retirement horizons vary, their tax brackets (now and projected brackets in retirement) and other individual situations come into play, there really is no set answer. However, it is prudent to consider this tax lessening strategy, because for MANY it is a worthwhile management tool.
If you feel like simply closing your eyes and waiting for it to be over during market swings and downturns, consider the strategy outlined here. You can take this time to do a little strategizing. A market downturn, with proper planning, in consultation with your tax adviser, might just be a great time for an IRA conversion.
You might just be able to turn those lemons into lemonade, after all!
Disclaimer: Writer is not a tax accountant or attorney, so please consult with your own tax adviser or financial planner before proceeding.