Roth IRA conversions can make sense in down financial markets

Financial planning generally anticipates, or at least hopes for, annual gains. But returns can be illusory, because what’s supposed to go up may not. That’s why a careful look at a Roth IRA as part of a retirement strategy is worth review, particularly following a down year in the financial markets.

The need for financial and accounting planning is described pretty well in dialogue from the movie “Apollo 13,” the near-disaster (“Houston, we’ve had a problem”) of an Apollo spacecraft on its trip to the moon. In the film, after the emergency occurs, the flight director says to an anxious roomful of mission control personnel: “Let’s work the problem, people. Let’s not make things worse by guessing.”

A strategy doesn’t guarantee success, but without one, it’s just guessing, which usually leads to more problems. An opportunity if in a down market may be to convert assets to a Roth IRA to achieve a tax savings.

In 2022, the Dow Jones Industrial Average was down nearly 9%, the Nasdaq fell more than 33%, and the S&P dipped by nearly 19.4%: it was the worst year for the markets since 2008. Using a Roth conversion strategy, a taxpayer’s option is to convert assets from a traditional IRA to a Roth IRA. A traditional IRA requires tax payments when money is withdrawn; however, assets in a Roth IRA grow tax-free because taxes are paid at the time the IRA conversion is made. From that point, every dollar added in growth is untaxed at distribution, assuming all legal eligibility and inevitable governmental strings are addressed, such as income levels and contribution limits.

Taxes are paid on the converted amount. The benefit is that you pay tax on the value as of today rather than the value of it in the future after appreciation. Partial conversions, rather than the entire amount, are also possible.

The down-market aspect comes into play because if a taxpayer’s income has dropped, or they’ve endured market losses and the IRA has decreased in value, there’s the possibility of paying less tax. For example, if a taxpayer’s traditional IRA is $500,000, and the value drops to $400,000, a Roth conversion means the tax paid at the time of conversion is on the lower amount. Additionally, the tax-free-at-distribution Roth component can also be assigned to eligible family members and heirs.

The IRS website lists new income phase-out ranges for contribution eligibility: “The income phase-out range for taxpayers making contributions to a Roth IRA is increased to between $138,000 and $153,000 for singles and heads of household, up from between $129,000 and $144,000. For married couples filing jointly, the income phase-out range is increased to between $218,000 and $228,000, up from between $204,000 and $214,000. The phase-out range for a married individual filing a separate return who makes contributions to a Roth IRA is not subject to an annual cost-of-living adjustment and remains between $0 and $10,000.”

To make the conversion, the three types of traditional IRA-to-Roth tactics are:

  • Rollover: The Roth contribution is made within 60 days after receiving a traditional IRA distribution.
  • Trustee-to-trustee transfer: The financial institution holding the traditional IRA is directed to transfer an amount to your Roth IRA trustee at a different financial institution.
  • Same-trustee transfer: If the traditional and Roth IRAs are at the same financial institution, the trustee can be directed to transfer the amount directly from the traditional IRA to the Roth IRA. Anything that touches taxes is going to come with a series of IRS what, when, how, why and other considerations, such as short- and long-term financial goals. Strategies should be considered from every angle, so it pays to engage an accounting professional or financial planner skilled in IRA law. That will help you arrive at a strategy, and to the maximum degree possible, without guessing.

This article first appeared in Knox News.

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