Why a down market is a “great time” for a Roth conversion

If you don’t have some niche investments, the value of your portfolio will be lower right now. The S&P 500 has surrendered nearly 18% over the past 12 months, and the broader bond market hasn’t fared much better, losing 13%.

But depending on your tax situation and what types of accounts you have, now may be a great time to transfer money from a traditional IRA to a Roth account, a move known as a Roth conversion.

Because Roths are funded with pre-tax money, you’ll owe a bill for any investments you roll over. But the lower the value of these investments, the less tax you pay.

“Now is a great time to talk about Roth conversions because the market is down,” says Brian Schultz, a certified public accountant and tax partner at Plante Moran accounting and wealth management. “The lower-than-normal price conversion has been too big for some investors who could have benefited.”

Here’s why financial experts say converting to a Roth can be a worthwhile move for anyone considering it right now.

To understand the benefits of a Roth conversion, it’s important to know the key differences between traditional and Roth IRAs.

Traditional IRAs are funded with pre-tax money, meaning you can deduct any contributions you make in a given year from your taxable income. But because you pay taxes up front, you’ll owe them when you withdraw money in retirement. If you withdraw before age 59½, you’ll owe a 10% penalty.

Roths, on the other hand, take no upfront deductions because you fund these accounts with money you’ve already paid taxes on. But after you turn 59½, you can take all your money, including investment gains, tax-free, as long as you’ve held the account for five years or more. You are allowed to withdraw up to the amount you contributed at any time without penalty.

Which account makes sense for you depends on your individual financial situation, but in general, if you expect to pay less in taxes in retirement, a Roth is recommended. That’s why many financial professionals recommend Roth IRAs for early-career investors whose paychecks will grow and push them into higher tax brackets.

Note that the government can also increase taxes. Because all the income you get from a retirement Roth is tax-free, these accounts can offer convenience to investors of any age, says Ed Slott, founder of IRAHelp.com and a certified public accountant.

“Your money grows income tax-free for the rest of your life, making it a good hedge against higher tax rates in retirement,” he said. “You can’t beat the 0% tax rate.”

While the above reasons can make a Roth conversion attractive to anyone who fears the tax rate will be higher in retirement, it can be especially beneficial for younger workers who expect to earn more income toward the end of their careers and near-retirees who fear the prospect of doing so. If the government raises tax rates, higher taxes will be owed on IRA distributions.

If this sounds like you, then why now is the time to do it.

Since you’re not taxed on any money in a traditional IRA, you’ll owe taxes if you convert to a Roth. But if the value of your portfolio is low right now, it’s cheaper than ever to move your stocks.

Say you own 10 shares of an ETF worth $100 each in a traditional IRA. If you convert it to a Roth, you’ll owe taxes on the dollar value of the shares: $1,000. But if your portfolio is down 20%, you can move those 10 stocks and pay $800 in taxes.

Once your stocks are converted, they will ideally continue to grow tax-free in your Roth account until you’re ready to withdraw the money in retirement.

“If you’re paying for something and it costs less, that’s good,” says Slott. “But you really don’t know when the market is going down. It’s hard to time the market for a Roth conversion.”

As Slott points out, the market can rise again or fall even further from current levels, so you never know if you’re getting the best deal possible.

So if you’re interested in converting, he suggests planning a series of small conversions between now and 2026, when the low tax rates in the Tax Cuts and Jobs Act expire.

“You can do it this year and then again in 2024 and 2025, and then it’s party over under current law,” Slott says. There is no limit to how much you can convert and how much you can convert in a year.

Like almost anything related to taxes and investments, Roth conversions are complicated moves that are best done under the supervision of a trusted professional.

There are also some downsides to consider when deciding whether this is a smart move for you.

First, they are permanent. You are no longer allowed to “recharacterize” your Roth conversion to a traditional IRA. If you convert some of your investments, the tax bill comes even if a financial emergency depletes your cash reserves between the time of the conversion and Tax Day.

Depending on how much money you transfer, one conversion can mean a huge income stream – potentially enough to push you into a higher bracket. This, in turn, may deprive you of certain tax benefits.

And don’t turn over any money you’ll need soon. You can’t withdraw your converted Roth funds or their earnings for five years after you switch, regardless of your age. If you do, you will owe tax and a 10% penalty on the amount withdrawn.

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