In these fleeting days of summer when the beach beckons and the pace of life slows, making financial decisions can seem as jarring as back-to-school sales in early July.
But if you’ve been considering a Roth conversion, you might want to visit your financial advisor next time you’re in town.
That’s because today’s down market is an opportunity to move funds from a traditional IRA or 401k to a Roth account at a “discount.”
Savings, You Say?
When it comes to Roth conversions, a depressed market can have a silver lining.
As the total value of your pre-tax IRA drops, the dollar amount you convert to a Roth represents a larger percentage of that pre-tax account. A pre-tax traditional IRA worth $500,000, for example, might be valued closer to $425,000, give or take, in today’s market.
By converting, say, $200,000 of that $425,000 while the market is down (rather than a portion of the original $500,000 during favorable market conditions), more of the future growth is shifted into the Roth, which offers tax-free growth, tax-free withdrawals, and no required minimum distributions (RMDs) once you reach age 72.
What’s the Catch?
A Roth conversion isn’t always a sunny day at the beach. Converting can be expensive since investors pay income tax on every dollar converted to a Roth.
What’s more, converting a large amount in a single year can bump you into a higher tax bracket—and the increase in income can impact more than just your taxes.
If you are on Medicare, the extra income can cause premiums to increase. If you receive Social Security, it can cause the percentage of benefits considered taxable to increase. A Roth conversion can even affect financial aid eligibility.
All held equal, today’s tax rates are some of the lowest in recent history. This means you’ll probably pay less for a Roth conversion now than later, particularly since tax rates are scheduled to increase in 2026—or potentially sooner.
Keep in mind, too, a Roth conversion today would most likely reduce RMDs down the road. That’s because RMDs are not required on Roth accounts.
Thinking of Your Family
While a Roth IRA is one of the most valuable assets you can leave your children or grandchildren, the SECURE Act tightened rules for inherited IRAs.
With some exceptions, beneficiaries must now deplete these accounts within 10 years of inheritance. This means they may ultimately pay taxes at higher rates over a shorter time.
To maximize the wealth you pass on to family, making a series of Roth IRA conversions could be more advantageous than burdening heirs with higher taxes on accelerated distributions from a traditional IRA.
This strategy is possible since you can convert any amount of money to a Roth at any time, even spread conversions across years to minimize your own tax impacts.
Key Considerations
Deciding whether a Roth conversion is right for you should be as simple as choosing between Manzanita and Cannon Beach for a weekend idyll, but there are many factors to consider.
Time horizon. The further away you are from needing funds, the more advantageous pre-paying taxes and converting to a Roth may be. A good rule of thumb is 10 to 15 years minimum.
Conversion timing. Since passage of the Tax Cuts and Jobs Act of 2017, you can no longer “recharacterize” a Roth conversion. In other words, once it’s done, there’s no undoing it. Given this, you may wish to wait until end of year to complete a Roth conversion until you have a better sense of the year’s total income. Alternatively, you can convert an amount now you know (with reasonable certainty) will NOT bump you into a higher tax bracket then shore up any remaining amount at year’s end. You can convert as many times as you wish throughout the year.
Future tax rate. If you think your tax rate will drop significantly in retirement, you probably don’t want to convert and pay taxes now at a higher rate. If you think your tax rate will stay about the same or rise, converting may net you more after-tax dollars in retirement.
Paying the tax. Ideally, you should be able to pay the tax on the conversion with cash. Tapping into an IRA to meet this expense would undermine the main purpose of the conversion, which is to maximize the long-term value of the tax-free Roth.
Already taking RMDs? If you are already taking RMDs, you will need to fulfill the RMD first before you can convert any additional assets out of the IRA.
Weighing the Variables
There are many considerations in determining whether a Roth conversion is right for you. Accelerating a portion of the planned conversion amount while the market is down is a great opportunity to convert a higher percentage of pre-tax IRA accounts to a Roth for the same amount of taxable income.
Vista is happy to help you determine how this strategy might fit into your financial plan.