Roth IRA conversions may be an attractive wealth management strategy during a down market

This article was originally written for wealthmanagement.com and was published as part of their semi-annual issue.

Market downturn may provide tax-saving opportunities

A significant stock market downturn, combined with inflation not seen in decades, interest rate increases, supply-chain issues, uncertainty caused by the ongoing war in Ukraine and the continuing repercussions of the pandemic have many financial advisors looking at different tax and wealth management strategies to benefit their clients.

One important strategy that has become more attractive for many individuals as the market has taken a significant hit over the last several months is converting traditional pre-tax individual retirement accounts (IRA) to Roth IRAs to take advantage of lower stock prices. The converted assets are taxed at their value in the year the conversion is made at an income tax rate then in effect rather than when withdrawals are made at a future time at a tax rate then applicable. Another reason to consider this strategy is that many believe personal income tax rates are likely to increase in the future. However, the client must have the funds outside of the IRA available to pay the tax that will be currently due .

Many advisors and individuals believe this is the time to make the conversion according to data provided by Fidelity Investments. Roth conversions were up by 18% for Q1 2022 compared to the same period in 2021.  

There are other factors that must be considered beyond potential tax savings to determine whether a Roth conversion is right for a particular client. First, it is important to understand the difference between a Roth and a traditional IRA.

Roth IRA vs traditional IRA

Roth IRAs and traditional IRAs are both important vehicles for saving for retirement. Both provide tax benefits. However, there are significant differences between the two.

Traditional IRAs are funded with “pre-tax” dollars. In other words, they are not subject to income tax during years in which the contributions are made. Rather, an individual is subject to tax when withdrawals are taken from the account. Current law provides that an individual must begin taking “required minimum withdrawals” (RMDs) during the year he or she turns 72 (70½ for individuals turning 70½ before 2020).

A Roth IRA requires the payment of income tax in the year the funds are contributed to the account. There is no requirement to make minimum withdrawals at any time (e.g., no RMDs), and no income tax is due when withdrawals are made (if properly done). However, there is an exception for Roth IRA conversions that is called the five-year rule. Individuals can’t make withdrawals from their converted balances for five years, no matter their age, or they will be subject to a 10% penalty. There are exceptions for the purchase of a first home or to have a child.

Additional benefits of converting

• Wealthy individuals making a Roth conversion during their lifetime reduce their overall estate and estate tax payable.
• Roth IRA distributions won't cause an increase in tax rates for the surviving spouse when one spouse is deceased because the distributions are tax-free.
• Post-death distributions to beneficiaries are tax-free.

Final thoughts

There are several other complex factors to consider before a decision to convert or not is made. This article discusses the highlights of the potential benefits/drawbacks of a Roth IRA conversion. Financial advisors should always consult with a tax expert before final decisions are made.