When stocks struggle or tread water, going Roth gains merit.
Converting a traditional IRA to a Roth IRA is no easy decision. After all, it is a taxable event. When the stock market is down or sluggish, however, a Roth conversion has more appeal.
Traditional IRA owners “go Roth” for
some very good reasons. A Roth IRA
can be a resource for tax-free retirement money. When you are 59½ or older and
have owned a Roth IRA for at least five tax years, you can make tax-free
withdrawals from your account.1
Original owners of Roth IRAs never have to contend with Required
Minimum Distributions (RMDs). They can also contribute to their IRA all their
lives, provided they have earned income below a certain ceiling.2,3
In a sense, a Roth IRA functions as a tax management tool in
retirement; you can put just about any investment subject to taxable income
into a Roth IRA and forego paying taxes on that income in the future.3
Many people retire to a lower tax
bracket. That fact alone is a good
argument for timing a Roth conversion to coincide with retirement.
For example, say you contribute to a traditional IRA while you are
working, all while you are in the 25% federal income tax bracket. Those
contributions come with a perk; you may be saving up to 25 cents on every
dollar you put into that traditional IRA, because traditional IRA contributions
are tax-deductible in many instances. In this scenario, as you retire, you drop
into the 15% federal income tax bracket. Making a Roth conversion at this point
also comes with a perk: the conversion now costs 15 cents on the dollar instead
of 25 cents on the dollar.3
Why is a poor year for stocks an
auspicious moment for a Roth conversion? In a beaten-down market, the cost of conversion can be lower for
retirees and pre-retirees alike.
As a mock example, suppose you own a traditional IRA that had a balance
of $180,000 at the end of last year. You had hoped the bull market would push
its value higher this year, but then the market waned, and now your traditional
IRA is worth $170,000. Bad news, yes; if you want to “go Roth” with that IRA, though, there
is a silver lining. The lower value of your traditional IRA means the tax bill
on the conversion (i.e., the tax owed on
the distribution of assets out of the traditional IRA) will be slightly lower.
Additionally, when the market rallies in the future, you get growth in a Roth IRA with the potential for
tax-free withdrawals, rather than growth in a traditional IRA where withdrawals
will be taxed as regular income.4
Other financial factors can make a Roth
conversion opportune. If you are
unemployed, have major health care expenses, or face a net operating loss
(NOL), it may also be a good time for this move. Any of these circumstances
could leave you in a lower income tax bracket. An NOL, in fact, can offset the
taxable income resulting from the conversion.4
If you are retired and in a low income tax bracket and have not yet
claimed Social Security, those three factors may put you in a nice position for
a Roth conversion.
A Roth conversion need not be
all-or-nothing. Some traditional IRA
owners opt for partial conversions; they “go Roth” with just a portion of their
traditional IRA funds. A Roth conversion can even be re-characterized; that is,
undone. If you want to undo a Roth conversion, in most cases, you have until
October 15 of the following tax year to do so.5
When is a Roth conversion a bad idea? A few scenarios come to mind. One, you lack the
ability to pay the income tax resulting from the conversion. Two, you are
positive that you will be in a lower tax bracket than you are now when you
start taking RMDs from your traditional IRA. Three, you have plans to relocate
to a state with minimal or no state income tax. Four, you think you might make
a major charitable IRA gift either at or before your death. Five, you are in
your peak earning years and, correspondingly, in the highest tax bracket of
your lifetime.
A Roth conversion is not for everyone,
but it could be for you. The
short-term tax hit may be a small price to pay for the potential benefits
ahead. If you want to explore this move, by all means, talk with a tax or
financial professional first. That conversation is essential.
Taylor McClish may be reached at 503.239.3060 or taylor.mclish@cunamutual.com.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.
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Citations.
1 - nerdwallet.com/blog/investing/know-rules-before-you-dip-into-roth-ira/ [1/29/16]
2 - irs.gov/Retirement-Plans/Roth-IRAs [12/17/15]
3 - time.com/money/4277306/how-to-contribute-to-a-roth-ira-if-youre-retired/ [4/4/16]
4 - usatoday.com/story/money/columnist/powell/2015/12/19/time-consider-roth-ira-conversion/75152514/ [12/19/15]
5 - irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-Recharacterization-of-Roth-Rollovers-and-Conversions [7/14/15]
04182016-WR-1616
1 - nerdwallet.com/blog/investing/know-rules-before-you-dip-into-roth-ira/ [1/29/16]
2 - irs.gov/Retirement-Plans/Roth-IRAs [12/17/15]
3 - time.com/money/4277306/how-to-contribute-to-a-roth-ira-if-youre-retired/ [4/4/16]
4 - usatoday.com/story/money/columnist/powell/2015/12/19/time-consider-roth-ira-conversion/75152514/ [12/19/15]
5 - irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-Recharacterization-of-Roth-Rollovers-and-Conversions [7/14/15]
04182016-WR-1616