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Why a bear market is a 'great time' for Roth conversions

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Unless you hold a few niche investments, your portfolio value is probably low right now. The S&P 500 has gained about 18% over the past 12 months, and the broader bond market hasn’t fared much better, having lost 13%.

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

Since the Roths are funded with the money you pay upfront, you owe a bill on every investment you pass on. But the less those investments are worth, the less you pay in taxes.

“With the market down, now is a great time to talk about Roth conversions,” says Brian Schultz, certified public accountant and tax partner at accounting and wealth management firm Plante Moran. “The conversion at a lower than normal cost has been huge for some investors who have been able to benefit.”

That’s why financial professionals say a Roth conversion could be a worthwhile move right now for anyone considering it.

Traditional vs. Roth IRAs: ‘You Can’t Beat a 0% Tax Rate’

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, which means you can deduct any contributions you make in a given year from your taxable income. But since you’re forgoing taxes up front, you owe them when you withdraw the money in retirement. You will also incur a 10% penalty if you withdraw the money before age 59 1/2.

The Roths, on the other hand, don’t come with an upfront deduction, as you fund these accounts with money you’ve already paid taxes on. But when you turn 59 and a half, as long as you’ve held the account for five years or more, you can withdraw all of your money, including investment earnings, tax-free. And you can 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 generally, a Roth is recommended if you expect to pay lower taxes now than when you retire. That’s why many financial professionals recommend Roth IRAs to early-career investors whose salaries are likely to rise and push them into higher tax brackets.

Keep in mind that the government can also raise taxes. But since all income you earn from a Roth in retirement is tax-free, these accounts can provide peace of mind for investors of any age, says Ed Slott, certified public accountant and founder of IRAHelp.com.

“Your money just grows for you tax-free for life, which makes the conversion a good hedge for higher taxes in retirement,” he says. “You can’t beat a 0% tax rate.”

Why a bear market is a good time for a Roth conversion

While the above reasons might make a Roth conversion attractive to anyone who fears their tax rate may be higher in retirement, it can be especially useful for young workers who expect to earn more later in their careers and near-retirees who fear they’ll owe taxes. higher on their IRA distributions if the government raises tax rates.

If this sounds like you, here’s why now might be the time to do it.

Since you weren’t taxed on any money from your traditional IRA, you owe taxes if you convert to a Roth. But if your portfolio value is low right now, it’s cheaper than usual to move your stocks.

Let’s say you own 10 shares of an ETF, each worth $100, in your traditional IRA. If you convert it to a Roth, you owe taxes on the dollar value of the shares: $1,000. But if your portfolio drops 20%, you can transfer those same 10 shares and pay taxes on $800.

Once your shares are converted, they will ideally continue to grow tax free in your Roth account until you are ready to cash out in retirement.

“There’s no question that if you’re paying for something and it costs less, that’s good,” says Slott. “But you don’t really know when the market is really down. It’s hard to time the market for a Roth conversion.”

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

That’s why, if you’re interested in converting, he suggests scheduling a series of small conversions between now and 2026, when the lower rates set out in the Jobs and Tax Cuts Act are due to expire.

“You could do it this year, then again in 2024 and 2025, and then the party, under current law, is over,” says Slott. There is no limit to how much you can convert in a single year or how many conversions you can make.

Beware of the downsides

Like most things involving taxes and investments, Roth conversions are complicated moves that should be done under the supervision of a trusted professional.

There are also some downsides to look out for when deciding if this is a smart move for you.

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

Depending on how much cash you move, performing a conversion could mean a huge influx of revenue – potentially enough to push you into a higher bracket. This could, in turn, disqualify you from certain tax breaks.

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

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