The stock-market plunge of 2022 has been painful for millions of investors. But a Roth IRA conversion offers an opportunity to turn this short-term negative into a long-term positive.
If you have a traditional individual retirement account (IRA), the federal government generally allows you to convert that account into a Roth IRA simply by filling out some paperwork and agreeing to pay taxes now on the amount you are converting.
If you convert $50,000 this year, for example, you would owe taxes on it by April 2023.
After doing so, you have the peace of mind of knowing you won’t have to pay taxes on any of that money in retirement, no matter how large the account grows. Part of the beauty of a Roth IRA is that you pay taxes upfront on the money you put in the account — which generally means you won’t owe taxes on any money you withdraw from the account in retirement.
A stock market downturn can be the perfect time to undertake such a conversion. Because the value of your account likely has dipped substantially, you have less money on which to pay taxes.
Let’s imagine two simple situations and how they might affect how much tax you pay on a Roth conversion.
In Scenario A, thanks to a booming stock market, your traditional IRA account has grown to $50,000. At that point — at the top of the market — you decide to convert to a Roth.
For the sake of argument, imagine your federal income tax rate is 24%. If your account total is $50,000 and you convert the entire balance to a Roth IRA, you would pay up to $12,000 in taxes.
In Scenario B, a bear market mauls your $50,000 portfolio, dropping it to $25,000. That is obviously not a good thing. But the silver lining is that if you convert the entire balance to a Roth, you would owe taxes on $25,000.
At a 24% tax rate, you would pay no more than $6,000 to Uncle Sam.
Again, this is a highly simplified example, and many other factors will determine the actual amount of tax you owe.
In addition, a Roth IRA conversion is not right for everybody.
For instance, your current income can play a big role in determining the wisdom of such a move. There are some other important rules and considerations to weigh. If you fumble a conversion, it can end up costing you money or might get you into hot water with the IRS.
A couple of years ago, USA Today ran down a few of the potential headaches a Roth conversion can create.
In short, it would be foolish to undertake a Roth conversion without consulting a tax pro. It also might make sense to stop by Money Talks News’ Solutions Center and find a financial adviser who can help you explore the wisdom of a conversion.
But the bottom line is that the deeper the market plunges, the more attractive a Roth conversion potentially becomes.
For more on getting the most from your investments, check out in “8 Ways to Maximize Your Traditional or Roth IRA.”