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Here’s a way to take advantage of the stock market’s dive: Consider doing a Roth conversion.
You take the retirement monies you currently have in traditional IRAs and move them to a Roth IRA. Given how the Dow Jones Industrial Average DJIA, +2.39% and the S&P 500 index SPX, +1.15% have plunged by about a third in recent weeks, your retirement account is worth a lot less than it once was. It also means your tax bill for a conversion will be less than when the market was higher just a few weeks ago.
A conversion is often touted as the way to avoid ever being forced to take a required minimum distribution (RMD) that is part of a traditional IRA. After a Roth IRA has been open for five years, it also allows you leave a tax-free inheritance to your heirs. Plus, when you take out money you do not pay taxes, another great advantage.
Read: How to decide if you should invest in a 401(k), Roth 401(k), IRA or Roth IRA
But before you decide to do a Roth conversion, consider these three questions.
1. Do you have the cash to pay the taxes now?
How much cash do you really have? Remember, you will have to pay taxes on this move. As the coronavirus pandemic shuts down businesses and is expected to cost millions their jobs, even temporarily, leave yourself plenty of wiggle room before you part with your cash for the Roth conversion taxes.
Without the cash to pay those taxes, you are taking money from a low-performing investment to pay this year’s taxes. But the ripple effect is even bigger. There will be even less equity to build for the long term. Plus, using the IRA funds to pay taxes now will not only dwindle your retirement funds but will count as a taxable withdrawal for 2020. This causes more income taxes and possibly a penalty if you are not over 59 ½ this year.
Read: This is how you can withdraw from your 401(k) at 55 — without paying a penalty
2. Do you have a Roth option through work?
Many companies have a designated Roth 401(k) option for retirement monies subject to the same rules as a traditional 401(k). Plus anyone with earned income can contribute to a Roth IRA within certain income limits. Your best strategy may be to start now making ongoing contributions to your Roth option at work or a Roth IRA. When you retire, you will have a mix of investments to choose from to make your retirement withdrawals without making a conversion.
Now that the age for taking the RMD on your IRA has moved to 72, from 70 ½, the tax impact of those payments may be less. This may impact your decision-making process more than what the stock market is doing currently.
Read: I have access to a Roth 401(k) at work. Should I open one?
3. What do you think your tax rate will be, now and in the future?
An advantage of a Roth IRA is that the when the money comes out, no income taxes will be due, because taxes have already been paid. When you take money out of traditional IRAs and retirement plans, you pay taxes at your marginal income-tax rate because the money that went into your IRA was income before taxes were taken out.
Your income tax for this year is based on earnings, so you can figure that rate since you can predict your income — or at least you could before the coronavirus pandemic hit. What a Roth conversion calls for is also knowing (or guessing at) your tax rate in retirement. The longer you have until retirement, the more unknown that is.
If you are currently working and in the 24% tax bracket, the current deduction for the money you stash away may be a nice annual tax savings and hard to lose. However, if you have significant assets that you will pay deferred taxes on in retirement, this may be a time to make a switch with the market down.
Read: Use this stock-market selloff to finally dump the funds you’ve long hated
Here are some essential facts to know on Roth conversions:
• Follow-through is important — 60 days is the limit between withdrawing money from your IRA and depositing into into a Roth IRA.
• Opening a new Roth IRA account is a necessity. Changing investment companies isn’t required.
• Check out the IRS rules here.
• Be sure about this decision as it cannot be undone. The 2017 Tax Cut and Jobs Act closed a loophole that let people reverse their decision.
Remember, a switch to a Roth is about your future withdrawals. Switching from a traditional IRA to a Roth will not make your investment returns better; you can change your investments anytime within your accounts.
Read: Here’s why you may want to reconsider doing that backdoor Roth IRA conversion
Whether to switch or not is a deeply personal and specific issue for you to consider.
In these times of stress and financial ambiguity, we all want to act. The best time to analyze and decide is from a clear place of understanding. If you need some help sorting through the details of your finances, this may be the time to find your own Certified Financial Planner to help guide you along the way. This website from the Certified Financial Planner Board of Standards can help you find one in your area.
Opinion:
CD Moriarty, CFP is a Vermont-based financial speaker, writer and coach who wants to create financial peace of mind for others. She can be reached through her website at www.MoneyPeace.com.
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