If you’ve ever been bowling with a child, you are familiar with bumper lanes. As an adult, we have a different view as we watch kids roll their ball aimlessly down the lane. Standing back, the ball moves left, to right, to left, back right again, over and over until finally it reaches the pins. You survive the whiplash of the back and forth, step back to check the screen, and find out the score.
In 2022, investors can relate to the back and forth as the volatility has continued down a long lane. The uncertainty of when this “whiplash” will end and we start to put positive numbers on the board is unknown. Fortunately, for those with qualified (pre-tax) money, there is a different way to ‘score’ along the way.
Individuals with a Traditional IRA can capture a silver lining to a down market by taking advantage of a Roth Conversion. For those who anticipate being in a higher tax bracket during retirement years, may want to increase the amount of tax free income they have in their spending years. While individuals at any income level can complete Roth conversions, the benefit is dependent on the individual’s tax rate today compared to their expected future tax rate. Typically, this means that it will be advantageous to make traditional contributions (and reduce taxable income) when ones marginal tax rate is higher today than when the funds are withdrawn in the future, and Roth conversions and contributions when the tax rate is expected to be higher than it is today.
A declining market can put the conversion “on sale” when the account values are suppressed due to a declining market. This is because as the Traditional IRA is depressed from it’s original value, the conversion is only taxed at it’s current value. For example, if your Traditional IRA had a balance of $100,000 but is currently at $75,000, you would pay income tax today on the $75,000. While the market or your account being down may seem like a bad thing, when it comes to paying taxes on that amount, it means you’ll have a lower tax bill. Consequently, as assets recover over time, you can later withdraw them from your Roth IRA tax-free.
It is important to know that you do not have to convert your entire Traditional balance at once and can choose the amount you wish to move to Roth. The amount that you convert will be taxed at your income tax rate in that year, so keep that in mind when planning for taxes.
There are a few other things to keep in mind before completing a conversion. The asset amount converted will be included in your Adjusted Gross Income (AGI) which can increase both your tax rate and potentially cause your Medicare premiums to change. A Roth IRA does not have a Required Minimum Distribution (RMD) like Traditional IRAs do, so you will not be required to withdraw a specified amount from your Roth beginning at age 72. And finally, the five-year rule in a Roth IRA restricts you to waiting five years before making a withdraw after the conversion or else you’ll pay a 10% penalty on any amounts withdrawn.
Market volatility certainly comes with the stress of wondering when we’ll finally start “knocking pins down” and requires patience and confidence you’ve aimed at the right target. Remember, there are still ways to take advantage of the situation along the way. Don’t worry if you feel confused about how to determine if a conversion is right for you, it is a complicated process. If you would like to discuss this strategy with a professional, reach out to me and we’ll schedule a call to answer your questions and help create a plan.
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