Is a Roth Conversion a Good Idea When the Market Is Down?
Soaring inflation, interest rate hikes and the war in Ukraine have sparked ongoing stock market volatility. However, there may be a bright spot: the chance to save money on a Roth conversion.
A stock market downturn may be a prime time for a Roth IRA conversion, reports CNBC. This is especially true if you were considering a Roth conversion and never got around to it.
How Roth Conversions Work
A Roth conversion allows higher earners to sidestep earnings limits for Roth IRA contributions, which are capped at $144,000 MAGI (Modified Adjusted Gross Income) for singles and $214,000 for married couples filing jointly in 2022.
Investors make non-deductible contributions to a pre-tax IRA, before converting funds to a Roth IRA. The tradeoff is the upfront tax bill created by contributions and earnings. The bigger the pre-tax balance, the more taxes you’ll pay on the conversion.
Why a Down Market Helps
The current market may make this a perfect time for a Roth conversion. Let’s say you own a traditional IRA worth $100,000, and its value drops to $65,000. You can save money by converting $65,000 to a Roth instead of $100,000. You’ll pay taxes on the $65,000, not $100,000.
According to Fidelity Investments, the first quarter of 2022 saw Roth conversions increase by 18%, compared to the first quarter of 2021. That was before the second quarter’s market volatility, which has been more dramatic.
Important Considerations
The decision to do a Roth conversion can’t take place in a vacuum. Consider how many years of tax savings it will take to break even on the upfront tax bill. Weigh combined balances across any other IRA accounts, because of the “pro-rata rule,” which factors in your total pre-tax and after-tax funds to determine your tax costs.
The Five-Year Rule
Attractive features of the Roth IRA are the freedom to take – or not take – distributions when you want, and there are no taxes on the withdrawals. However, there is an exception pertaining to conversions: the five-year rule.
If you do a conversion from a traditional IRA to a Roth IRA, you have to wait five years before making any withdrawals of the converted balance, regardless of your age. It’s an expensive mistake, with a 10% penalty. The clock begins running on January 1 of the year of the conversion. If you are close to retirement and will need funds within that time-frame, you’ll need other assets to live on.
Medicare Premium Impact
If the conversion increases your Adjusted Gross Income (AGI), it may create other issues. Medicare Part B calculates monthly premiums using Modified Adjusted Gross Income (MAGI) from two years prior, which means a higher income in 2022 will lead to higher Medicare bills in 2024.
Before doing a Roth conversion, evaluate your entire financial and retirement situation. If you or a loved one needs assistance with elder law or estate planning issues, do not hesitate to contact The Stegall Law Firm to schedule a consultation.
