If you’ve been thinking about converting a traditional IRA to a Roth IRA, here’s the 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 valued at a lot less than they were a year ago, or even in January, so the amount of tax you’d have to pay on the conversion will be less, as well.
“Lower markets present opportunities to make Roth conversions with a lower tax impact,” Mark Wilson, the president of Mile Wealth Management in Irvine, Calif., tells me. “I would be looking at these opportunities.”
Call it your “bear market bonus.”
Roth IRAs are retirement accounts on which you’ve already paid all the tax. You contribute with after-tax dollars, but after that you (theoretically) never 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 low-level but persistent fear that Congress, faced with budget shortfalls in decades to come, may suddenly redefine Roths as “loopholes” or “giveaways” to the rich (you know the drill), and start taxing them twice.
By contrast, traditional IRAs are those where you contribute pretax dollars — you can deduct the contribution on your federal and state tax return — but where you will owe taxes later, when you withdraw the money.
There is a lively and persistent debate about whether traditional IRAs or Roths are “better,” and why. Some of it really depends on your circumstances.
Surging inflation in the past year is strengthening, slightly, the arguments in favor of Roths. That’s because it will threaten more retirees with tax on their Social Security benefits, through the phenomenon known as “bracket creep”: Your nominal income rises, but the tax thresholds or brackets don’t.
“The Roth IRA benefits really shine as you can withdraw money in retirement income tax-free 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 do not have any effect on the taxability of Social Security benefits.”
Those who say I am too cynical about Congress and Roth IRAs, and insist Congress would never tax the money twice, should remember that Social Security benefits used to be tax-free because you already made your contributions with after tax dollars. In other words, you’d already paid tax on the money. But in the 1980s Congress changed the rules and started taxing benefits as well: A double tax.
Naturally, at the time they said it would only apply to the highest earners: About 10% of retirees. But here we are and it now applies to about half. And the percentage is rising steadily every year.
One of the many arguments in favor of traditional IRAs is that they always offer you the option of later converting them to Roths. 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 amount of the transfer on your federal tax return as income for the year.
That’s where the market slump can work in your favor. So far this year the S&P 500 SPX, -1.13% and the global MSCI AC World Index ACWI, -1.23% are each down nearly 20%. The U.S. bond market is down about 12%. Conversions at these levels escape some of the tax you would have paid if you’d done it late last year.
But Wilson warns this isn’t a one-way bet. “I would warn folks not to be too aggressive with Roth conversions (especially very big ones),” he says. “ Volatile markets tend to be volatile for a while and the converted amount could continue to drop in value resulting in taxes on a value that’s no longer there. (There are no ‘undos’ with Roth conversions anymore.) 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 soon are already regretting it. “Roth conversions are looking goofy now as the contributions made in January are below water already,” he says.
There again, you can’t time the market. If things turn around, sooner or later, the missed extra savings won’t hurt quite so much.