There’s no doubt that markets have recently taken a retreat. How long markets will stay low is anyone’s guess. As I’ve mentioned in the past, when markets are volatile investors need to be cautious about overreacting. That being said, investors should also look for opportunities when markets temporarily head south. One of the opportunities investors should explore is a Roth conversion.
There are two basic types of IRAs: a traditional IRA and a Roth IRA. The main difference is how they are taxed. In a traditional IRA, money grows on a tax deferred basis and when money is withdrawn it is subject to ordinary income tax. In addition, in a traditional IRA, once you turn 70½ you must begin taking required minimum distributions. In a Roth IRA the tax consequences are totally different. First, money in a Roth IRA grows tax free. When money is withdrawn from a Roth IRA there are no taxes owed. In addition, Roth IRAs are not subject to required minimum distributions. Thus, you can let a Roth IRA grow tax free for as long as you choose.
For those of you who have money in a traditional IRA, a conversion is where you take money from the traditional IRA and move it into a Roth IRA. The advantage of this transaction is that you’ve converted tax-deferred money into tax-free money and you’re not subject to the 70½ rule. Therefore, doing a Roth conversion not only makes sense economically, but also from a tax standpoint for many people. When markets are down it allows you to convert more shares from a traditional IRA into a Roth IRA. For example, let’s say you owned a stock that a few months ago was selling for $15 a share but it is now selling for $10 a share. If you owned 100 shares of that stock and you converted it when it was $15 a share, you would have a $1,500 tax consequence while if you did it when the stock was at $10 a share, the tax consequence would only be $1,000. Therefore, because markets are temporarily low, it creates opportunities for more and more people to take advantage of a Roth IRA conversion.
My general rule for doing a Roth IRA conversion is 1) you have to have the money to pay the tax on the amount converted without touching any of the converted funds; 2) by paying the tax on the conversion it would not throw you into a higher tax bracket and; 3) you can leave the money in the Roth IRA for at least five years. If you meet those requirements, converting into a Roth IRA can make sense.
I am a big fan of Roth IRAs and I encourage more and more people to look into them. My reasoning is twofold. The first is the fact that there potentially can be a significant tax savings. After all, money growing tax deferred is not worth nearly as much as money growing tax free. The other reason I like Roth IRAs is I believe they give you greater flexibility than a traditional IRA. There are many people who once they turn 70½ don’t need the money and would prefer to leave the money in the traditional IRA growing on a tax-deferred basis. Unfortunately, you can’t do this because of required minimum distributions. On the other hand, in a Roth IRA, you have flexibility because you can let it grow tax free for as long as you choose.
Many people who consider a Roth IRA conversion generally wait until the end of the year. As far as I’m concerned, why wait. If you’re thinking about doing a Roth conversion, the fact that we have a down market creates an excellent opportunity for you.
Once again, like everything else in the financial world, Roth IRA conversions are not for everyone. However, if you meet the three criteria that I’ve outlined above, a Roth IRA conversion can provide an excellent opportunity for you.
You and I cannot control the market. However, we can look for opportunities to take advantage of it. The key is don’t procrastinate or try to time the market and wait until the market is at its ultimate low. It would be nice if you could do that, but you won’t be able to. Therefore, since the market has taken a significant downturn, now is a great opportunity to take advantage of a Roth conversion.
Good luck!
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com.