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It can be challenging to manage your finances when the market is experiencing a downturn. Your expenses shoot up as the inflation begins to rise while the value of your investments starts going down. Due to some of the recent and ongoing global crises such as the Covid-19 pandemic and the Russia-Ukraine war, investors are facing one economic debacle after another. That said, you cannot get sucked in and lose sight of your aim - long-term financial planning to secure your financial future. Hedge your bets on long-term investments. By focusing on the long-term, you can sail through short-term market volatility and attain your future financial goals. Both the 401(k) and Individual Retirement Account (IRA) have been two extremely popular long-term investment instruments for investors in the United States. When the market is facing a downturn, an IRA may offer you a different option to consider.
Simply put, an IRA is a tax-advantaged retirement saving account that investors can open to save and invest to secure their financial future. There are primarily two kinds of IRAs – traditional and Roth. The major selling point of a Roth IRA is the ability to make tax-free withdrawals in retirement. You also have the option of converting your traditional IRA to a Roth IRA. This may be a prudent idea especially when the market is down. To understand how a Roth conversion works, its benefits and drawbacks, and would it be a wise investment for you or not, consult with a professional financial advisor who can advise you on the same.
In this article, we will discuss everything that you need to know about a Roth conversion and the things you should keep in mind when converting your traditional IRA to a Roth IRA.
What is meant by a Roth conversion?
To put it succinctly, a Roth conversion is a transfer of retirement funds from a traditional IRA or 401(k) to a Roth IRA account.
In a traditional IRA, you contribute your pre-tax dollars toward investments that can grow tax-deferred, however, your withdrawals are taxed in retirement as per ordinary income. You can make withdrawals after reaching 59.5 years of age. On the other hand, in a Roth IRA, you contribute your after-tax dollars allowing your money to grow tax-free. You can make tax-free withdrawals in retirement after reaching 59.5 years of age and having held your Roth IRA account for at least five years.
If you expect to be in a lower tax bracket post-retirement, a traditional IRA would be a preferable option for you since you receive immediate tax relief and save money in the present. However, if you expect to be in a higher tax bracket in the future, then you should opt for a Roth IRA account. This would allow you to pay tax in the present and draw tax-free money in retirement. Further, you are not required to take out mandatory distributions in retirement in a Roth IRA, however, the Internal Revenue Service (IRS) mandates that you must take Required Minimum Distributions (RMDs) after the age of 72 if you own a traditional IRA account.
For 2022, you can contribute $6,000 to your IRA account. But if you are 50 years of age or older, you can make an additional catch-up contribution of $1,000, bringing the total to $7,000. This limit is applicable to both traditional and Roth IRA accounts.
There are several benefits of a Roth conversion. That said, it is important to know when you should go for a Roth conversion to benefit from it.
What happens to your IRA if the market crashes?
You can invest your money in several traditional forms of investments like stocks, mutual funds, exchange-traded funds (ETFs), bonds, certificates of deposit (CDs), and money market funds in your IRA. However, you can also invest in alternative investments such as cryptocurrency through Bitcoin IRAs. In a Roth self-directed IRA (SDIRA), you can invest in real estate, franchise businesses, gold, and partnerships. Through these investments, you can accumulate wealth but keep in mind that since all of these investment options are linked to the market, if a market crashes your investments will also lose their value.
Let us run through this scenario so you can understand what happens when a market falls. Your stock prices plummet, mutual fund returns take a sharp nosedive, and your ETF returns decrease. Though you may cover some of your losses through bonds, your overall returns may still be lower than what you may expect or want them to be. Your IRA value can significantly reduce depending on the prevailing market forces. That said, you can recoup your losses in time when the market recovers and bounces back. An IRA is a long-term investment vehicle that affords you that opportunity.
Should I convert my IRA to a Roth IRA?
The primary reason behind choosing to go for a Roth conversion is to save taxes in the future. Most folks are of the opinion that their present tax output is high. Considering this is the view when they are earning an income, it should be no surprise that people want to save money on paying taxes in retirement when their income would most likely come from investment returns and savings. This is a limited pool of funds, hence, any kind of taxes that are levied on your retirement money would create a shortage of funds. If you pay tax now, you would not have to do so during your retirement years, especially when you would most likely not have a stable source of income. Doing so would help protect your limited savings pool. That said, you need to understand certain aspects of this decision before you take the step:
1. Go for a Roth conversion only if you have sufficient funds to pay taxes right now:
At the time of Roth conversion, you need to pay taxes owed on the money that was growing tax-deferred till now. These funds will be taxed as per your current annual income. If you are a high-income earner, chances are you will already be paying a high amount of income tax. By converting your traditional IRA funds, you will further increase your tax output. This can be challenging especially if you do not have sufficient funds. In addition, if there is an ongoing market downturn, you need to consider other factors too. First among them is employment. Currently, economists are saying that a recession may soon be approaching. If and when that happens, it may result in unemployment, inflation, and salary cuts. We are already experiencing record levels of inflation. If you lose your job or have to take a pay cut, you would require funds to offset the loss of an active income. Going for a Roth conversion at this point in time may be tricky as you may not have enough money to cover the taxes.
2. Consider converting to a Roth IRA if you have a lower income in the year of conversion:
As stated above if you receive a pay cut, you may find it difficult to pay the due taxes on the conversion. Do note that these taxes need to be paid upfront. That said, you can benefit from this turn of events. Since your IRA funds will be added to your ordinary income and taxed accordingly, if at the time of conversion you are in a lower tax bracket, paying the taxes on the IRA money will not increase your tax burden significantly. So, if you have taken a hit on your income and it is lower than expected, you can think of switching to a Roth IRA account and reducing the impact of the tax hit.
3. Consider a Roth conversion only if you expect your future tax rate to be higher:
Choosing to go for a Roth conversion depends on what you expect to happen when you reach retirement. If you expect you would be in a lower tax bracket during your golden years, then it is better to stick to a traditional IRA. Your priority should be to lower your taxes. Consult a financial advisor who can assess your investment choices and the returns that they are likely to generate. If you are on your way to building a significant retirement corpus, your money will not be taxed during your retirement if it is kept in a Roth IRA. If you go down this road, not only will you avoid paying taxes in the future but also enjoy a higher monthly income after retirement.
4. Consider a Roth conversion if you wish to leave a legacy for your heirs:
One of the major plus points of owning a Roth IRA account is that you do not have to take obligatory RMDs. Unlike traditional IRAs where you have to start taking mandatory distributions from the age of 72, you can leave your Roth funds untouched if you have enough savings to meet your retirement expenses. You can leave your Roth IRA account to your family after your demise to meet their financial needs. Furthermore, your beneficiaries will not have to pay any taxes on the said funds if your IRA has been open and active for at least five years. Otherwise, your heirs may have to pay a 10% penalty on the withdrawn funds.
5. Opt for converting your traditional IRA into a Roth IRA if you are not retiring soon:
A Roth conversion would not be ideal for you if you plan to retire in less than five years and would require your IRA funds in retirement. As per IRS rules, all IRAs have a five-year rule. This rule states that all account holders have to wait for at least five years after the account is opened to withdraw their money. Irrespective of the fact that you owned a traditional IRA before for a number of years, the five-year rule will come into effect at the time of a Roth conversion. This is because the conversion is treated as a new account. Say, for example, you converted your traditional IRA in 2021, you would be able to make a withdrawal only in 2026, provided you are 59.5 years of age at the time of withdrawal. In case you retire before 2026 and make a withdrawal from your Roth account, a 10% penalty would be levied on the withdrawn money.
Apart from these factors, if you opt for a Roth conversion when the market is down, it would be advantageous for you. Let us discuss this in more detail.
Is opting for a Roth conversion when the market is down a good decision?
Yes, it is. The timing is ideal to consider a Roth IRA conversion. At the time of converting your traditional IRA to a Roth IRA, not only do you have to pay tax upfront on all your pre-tax contributions but also on the earnings accrued by you. This can be a significant payment and largely depends on your term of investment and the kind of investments made in your traditional IRA. But during a market downturn, the value of your IRA investments falls. For instance, suppose you had $150,000 in your traditional account when the market was up. At this time, you would have had to pay tax on the entire sum of $150,000. But if your investments fall to $100,000 due to market volatility, you would be required to pay tax on the $100,000 and not $150,000. Simply put, the lower the value of your investments, the lower the tax levied on them. By taking advantage at the time of a market downturn, you lower your tax liability compared to when the market was performing well and the value of your investments was higher.
Now when the market would recover, your investments in all likelihood would recover as well. You can then again be well on your way to attaining your financial goals with the added benefit of having paid off a significant tax liability. Moreover, not only would you have saved taxes but can look forward to making tax-exempt withdrawals and not having to take mandatory RMDs in retirement.
Do note that the year in which you make a Roth conversion, that year’s modified adjusted gross income (MAGI) may increase. This is important because MAGI can affect the monthly premiums for Medicare Part B since the premiums are calculated on the basis of the last two year’s MAGI. Hence, a Roth conversion may lead to a higher premium in 2024.
Can a 403b be rolled over to a Roth IRA?
A 403b is a retirement savings plan created exclusively for employees of public schools and tax-exempt organizations. For 2022, you can make a contribution of up to $20,500 each year, and if you are 50 or older, you can make an additional contribution of $6,500, bringing the total to $27,000. You can invest in money market accounts, mutual funds, and annuities through your 403b plan.
You also have the option of converting your 403b plan to a Roth IRA by either transferring your 403b funds to your Roth account or withdrawing the money and then subsequently depositing it in your new Roth IRA. This must be done within a period of 60 days. Do note that both these actions attract taxes so make sure you have studied the implications of a Roth conversion thoroughly before taking the decision.
To conclude
Opting for a Roth conversion can help you save money since you can make tax-free withdrawals in retirement while most other investment instruments are taxed in retirement. In addition, you would be able to lower your immediate tax liability if you go for a Roth conversion when the market is going through a down cycle. That said, you must understand the different aspects of a Roth conversion before considering such a decision.
Do reach out to a financial advisor who can offer you better clarity on the benefits and drawbacks of a Roth conversion, and precise tax implications for you. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.