With the S&P 500 stock index down about 8 percent since the start of the year, "Ignore your portfolio balance" has become a familiar refrain for many individual investors. But for even the most Zen investor, dwindling retirement savings and worrying financial headlines can make it difficult to look away. For those itching to make a move, though, it turns out there is one thing you can do to improve your financial situation: a Roth IRA conversion.
Roth conversions — transferring funds from a traditional pretax individual retirement account to a post-tax Roth IRA — can be done at any time. Taxes will be due on the amount you convert, but you won’t be charged a penalty, and your growing retirement savings will never be subject to taxes again. When your IRA value is down, you’ll pay less in taxes on the conversion by virtue of the fact that your balance is lower than it was before (thanks to the recent market decline) and hopefully will be again.
“Any Roth conversion where you’re actually paying taxes is ideal to do in the midst of a big, bad bear market,” said Dr. James M. Dahle, author of “The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing” and an emergency physician based in Salt Lake Valley, Utah. “When the market is down you get a discount to do it.”
It's relatively simple to convert to a Roth IRA. Take some or all of the money in your traditional IRA and roll it over into a Roth IRA. It’s as easy as making a phone call to your adviser or the brokerage firm where your IRA is held. Roth conversions can also be done within some 401(k) plans if your provider allows for it.
When the market rebounds and your retirement portfolio follows suit, you’ll have the benefit of tax-free growth in a Roth IRA rather than in a traditional IRA, which requires taxes be paid when the funds are withdrawn during retirement. That may sound like a good deal, and it can be, but the strategy isn’t for everyone. Before doing a Roth conversion, consider what your tax rate is today and what you anticipate it will be moving forward.
“The driving force on when a Roth conversion is a good deal is whether you can convert the money now at a tax rate that is lower than you would pay in the future,” said Michael Kitces, a certified financial planner and director of financial planning at Pinnacle Advisory Group.
The IRS calculates the taxes on a Roth conversion for the year in which it takes place. That means you won’t actually report the conversion or write a check to the IRS until April 15 of the following year, when you file your tax return.
Although the tax savings can be significant if the market quickly rebounds after the Roth conversion, the IRS offers a sort of reset button in case it doesn’t. Investors can undo the conversion by transferring the money from the Roth back to the original IRA at any point before reporting the conversion. “You’re allowed to re-characterize a Roth as late as your tax-filing deadline in the following year plus extensions,” Kitces explained.
Given the re-characterization rules, most advisers recommend completing the strategy earlier in the year and then waiting to see how it pans out. “Sometimes it’s hard to tell if the market is going to go up or down from here. It might be better next month, but it’s clearly better than a month ago,” Dahle said.
To make it easier to potentially re-characterize a Roth conversion, Kitces said it’s better to open a new Roth IRA rather than commingle the conversion funds with an existing account. That way, if the balance does decline, it will be clear which losses are related to the conversion.
“A lot of people think of Roth conversions as all or none, and they’re not. You can do anything between 0 percent and 100 percent,” Kitces said. “Do exactly enough to fill your tax bracket and then stop and wait until next year.” Kitces recommends systematic Roth conversions done over time to maximize the potential tax savings.
Unlike Roth IRA contributions, which are limited to $5,500 in 2016 ($6,500 for those 50 or older) and have income limits as well, anyone can make a Roth conversion. The only catch is the tax is due on the transfer, as the money moves from a pretax to an after-tax account. Depending on your tax bracket, the amount can be significant.
For example, someone who is currently in the 25% tax bracket will pay $2,500 in taxes to convert $10,000 from a traditional IRA to a Roth IRA. If that balance has recently declined to $8,500, the taxes due will only be $2,125, an immediate savings of $375. Taxes cannot be paid from the IRA itself, so it’s important to have cash on hand to cover the extra amount.
According to Kitces, those who benefit most from a Roth conversion tend to be younger workers who expect to earn more and have higher tax rates as their career progresses, and recent retirees who find themselves in a lower tax bracket. “We often see a sweet spot between when you stop working and your wages go away, and before your required minimum distributions begin,” he said. For those in their peak earning years, the tax bill on a Roth conversion may be more expensive than it’s worth.
Although a Roth conversion is relatively simple, in theory it can get complicated in practice, especially if you have more than one traditional IRA or significant retirement savings. A good accountant can help, but it’s also possible to navigate the details yourself by turning to reputable blogs and online forums.
“There are plenty of instructions out there that will literally take you through step by step,” Dahle said. “It seems intimidating to people the first time they do it, but it’s really quite straightforward.”