A market downturn can be a scary time for investors, but it can also be a great opportunity to do a Roth conversion. When the market is down and the value of your retirement account is lower, you will save money on taxes. This is because you are converting your pre-tax account into a post-tax account. And when the market rebounds and your account recovers, you’ll have a larger account in a Roth that you then don’t have to pay any taxes on the distributions!
What is the difference between a Traditional and Roth IRA?
The biggest difference between a Traditional IRA and Roth IRA is how they are taxed. With a Traditional IRA, your contributions are made with pre-tax dollars. This means that you will not pay any taxes on your contributions until you make withdrawals in retirement. With a Roth IRA, your contributions are made with after-tax dollars. This means that all growth and distributions within the account are tax-free since you already paid income taxes on the contributed amount.
Why is a market downturn is a great time for a Roth conversion?
When the stock market is down, there are generally two things happening with people’s portfolios. Investors are selling off investments that have lost value and they are also contributing less to their accounts because they feel less confident about the future.
If you sell your investments when the market is down, you lock in the loss on the investment and let go of the opportunity for the investment to recover, however, a Roth conversion allows you to take advantage of the market downturn.
When you convert your retirement account to a Roth IRA, you are essentially selling your investment at its current value and then reinvesting it in a Roth IRA. This means that you will pay taxes on the conversion at the lower account value. And, if the market rebounds, as it typically does, then when you take distributions from your account at retirement, you won’t pay income taxes on the account at all.
The simplest way to describe the process is with the following scenario.
Say you have $100,000 in a Traditional IRA at the beginning of the year. Six months later the value of the account has dropped to $75,000. By completing a Roth conversion when the account is down, you only pay income taxes on $75,000 instead of $100,000.
Benefits of a Roth IRA
There are many benefits of a Roth IRA, but the biggest one is that all growth and distributions are tax-free. This means that you don’t have to pay any income taxes on the money you take out of your account at retirement.
Another great benefit of a Roth IRA is that there are no required minimum distributions as there are with Traditional accounts, so the money can continue to grow as long as you want it to. Roth IRAs are also passed down tax-free, so your heirs won’t have to pay taxes on the amount inherited.
While a market downturn can be a scary time, it also can present an opportunity for those willing to take advantage of it. A Roth conversion during a market downturn allows you to pay taxes on a lower account value and then take distributions tax-free in retirement. It is just one of the many benefits of a Roth conversion in times of volatility.
So, if you’re considering a Roth conversion, remember that a market downturn can be the best time to do it.