When markets experience periodic cyclical downturns reviewing an account statement can cause heartburn. While lower values are often unwelcome in the short-term, they may provide planning opportunities that may help to improve your financial picture in the long-term. One such opportunity that you may want to consider in consultation with your tax and legal advisors is triggering a Roth IRA Conversion while your IRA is at a lower market value.
What is a Roth Conversion?
Individual Retirement Accounts (IRAs) generally come in two flavors. Traditional IRAs are often funded with contributions that are tax-deductible, but the trade-off is that distributions are subject to income tax when they are taken out. In contrast, Roth IRAs are funded with contributions that are not tax deductible, but the benefit is that qualified distributions are not subject to income tax when they are removed. Not everyone is permitted to make Roth IRA contributions as the law currently prohibits individuals over a certain income level from participation.
A Roth conversion takes place when the owner of a traditional IRA, after consultation with their tax and legal advisors, decides to move the assets into a Roth IRA. The IRA owner will have to pay income taxes based on the value of the assets in the traditional IRA at the time of conversion, but the transaction will not trigger early withdrawal penalties for those under age 59 1/2. Unlike Roth contributions, Roth conversions are not subject to an income limit and thus available to people of all income levels.
Is a Roth Conversion right for me?
Everyone has a unique financial picture, and there are several factors that you must consider when you work with your team of advisors to determine whether a Roth conversion is the right strategy for you. In fact, if you own a traditional IRA it may be most beneficial to evaluate Roth conversions on an annual basis. As you complete your assessment, here are a few factors that you may want to consider:
- Do you believe that tax rates will be higher in the future? Many people see benefits in paying the income tax now at a known rate rather than running the risk of taking taxable distributions in the future when tax rates could be higher.
- Is your current income tax rate likely to be higher or lower in retirement? If you expect to have relatively low-income tax rates in your retirement years or currently pay taxes in one of the higher brackets, then a Roth conversion may not make sense for you.
- How long is your time horizon for retirement? Roth conversions are most effective when the account owner is further from retirement. Someone who does a Roth conversion at age 30, for example, can potentially benefit from decades of tax-free growth before they reach retirement. In contrast, if someone is less than five years from retirement then the account may not have sufficient time to grow enough to outweigh the cost of the taxes paid.
- Do you have sufficient funds to pay the additional income taxes up front? If you need to withdraw extra funds from your traditional IRA to meet the additional tax burden, a Roth conversion may not be right for you.
Answering a few simple questions can help you determine if converting is right for you?
Do you think you will be in the same or higher tax bracket when you retire?
| If Yes | If No |
|---|---|
| Do you expect to start making withdrawals after five years or more? | Converting to a Roth IRA may not make sense if the conversion tax rate is greater than future tax rates. |
| Do you have enough money out of pocket to pay the taxes due on the conversion? | If your time horizon is not sufficiently long enough, the tax-free earnings of a Roth IRA may not have time to grow to offset the taxes paid at the time of the conversion. |
| A Roth conversion may make sense for you. | If you can’t pay the taxes incurred from the conversion using other sources, then converting to a Roth IRA may not make sense. |
Why is this important in a down market?
When the value of a traditional IRA decreases with a market correction the potential income tax liability can also go down. Because you are paying income taxes based upon a lower market value, the assets are effectively “marked down” during the downturn. Ultimately, the conversion can also potentially increase your ultimate cash flow in retirement as funds distributed from a Roth will not be subject to income tax. Although these factors are relevant for analysis of a Roth conversion in any economic climate, they have the potential to become “supercharged” when markets are lower.
Example: You have a traditional IRA that was valued at $500,000 shortly before a market downturn. Your team of advisors have recently suggested that you consider a Roth conversion for the entire account. The market correction pushed the IRA value down to $400,000. If you trigger a conversion now, when the IRA assets are “on sale,” the result may be a lower income tax bill. Assuming your effective income tax rate is 25%, converting during a market dip in this case could mean an income tax savings of over $25,000 in the first year alone. When the Roth IRA funds are eventually withdrawn in retirement additional income taxes savings will be realized.
Getting the advice you may need
There are many steps one can take to prepare for a down market, and even a few during a down market. Converting your traditional IRA to a Roth IRA is one option to discuss with your tax and legal team. To learn more, please contact your Huntington advisor or visit a Huntington branch for more information on our wealth management services.
