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  • Roth IRAs offer tax-free growth and tax-free withdrawals in retirement.
  • Converting assets from a traditional IRA to a Roth IRA requires an upfront tax payment. Still, tax savings could be significant if your effective tax rate will be higher in retirement than it is today.
  • Declining stock values can mean you'll pay fewer taxes to convert your assets this year.

It could be an excellent time to sit down with your accountant and tax attorney to discuss the benefits of shifting retirement assets from a traditional IRA to a Roth IRA.

Traditional IRAs are funded with untaxed dollars upfront, so withdrawals are subject to taxes at your prevailing income tax rate in retirement. However, Roth IRAs are funded with after-tax dollars, so withdrawals from those accounts are tax-free in retirement.

Therefore, if you think your income tax rate in retirement will be higher than it is today, converting to take advantage of a Roth IRA's tax-free growth and withdrawals can make sense.

Of course, you'll have to pay taxes at our current income tax rate on any assets you convert from a traditional IRA to a Roth IRA. However, your tax bill could be smaller this year because falling stocks have likely reduced your account value.

In "This Year Has Been Ugly. Here's a Trick to Make Up Some of the Damage," Real Money Pro's Paul Price explains why he's using this year's bear market to convert some of his IRA. He writes,

“The first half of 2022 was one for the record books, but not in a good way. This will have been the worst first half of the year in decades. The tidbit below, though, can give heart: There's never been a 15% or more, 6-month decline, to start a year that did not precede a much better second half. Knowing that the odds are now in our favor suggests it's a fabulous time to consider doing full, or partial conversions of traditional IRA holdings into Roth IRA accounts.”

Price lists the advantages of having assets in a Roth IRA, especially for high-net-worth individuals. He writes:

"What are the benefits of doing Roth Conversions?

  • Transferring shares, which are way down in value, means paying less tax on the privilege of converting. You are only charged for the value at the time of transfer, not the substantially higher price you might have paid.
  • You cannot write off losses in tax-sheltered accounts, but converting beaten-up shares that later recover accomplishes the same effect over time.
  • Taxes can be deferred until April of 2023 (if you desire) by choosing not to withhold taxes at the time of transfer.
  • Future rebounds in price will be tax-free forever in a Roth IRA, barring an unexpected change in tax policy. Changing the rules on Roth IRA taxation would be so vilified by the public that no politician would want to be the one who proposes it.
  • Future mandatory distributions, currently slated to kick at 72-years of age, would likely be reduced vs. non-converted assets. That is because they are calculated on the Dec. 31 value of your Traditional IRA in the year before the distribution will take place. (Author's note: Required minimum distributions begin at age 72 for traditional IRAs, however, this rule doesn't apply to Roth IRAs).
  • If you are lucky enough to have accumulated substantial wealth over your lifetime prepaying taxes on Roth Conversions will lower estate taxes, as well.
  • The younger you are at the time of conversion, the more ultimate benefits you are likely to obtain.
  • All future dividends, covered call premiums received, and/or interest earned in the Roth account will be tax-free forever. If earned in Traditional IRA status they'd be taxed at your highest marginal rate upon withdrawal."

Price offers an example of how converting some of his shares this year could save him big money over time. Specifically, he's converting shares of two value stocks that have sold-off but could rally sharply: American Woodmark Corporation  (AMWD)  and Berry  (BERY)

He writes:

“I've been moving even more money over the past month or so to take advantage of insanely low valuations on many of my favorite stocks that made up good chunks of my traditional IRA. Here is the math on a $100,000 transfer value of American Woodmark Corporation and Berry moved at today's price points. I fully expect that both will more than double over the coming 12 to 18 months, and perhaps sooner.

CHART-Recession3_070122

If you were in a higher tax bracket, then you could save even more if stocks you convert rally back more in value than you pay in taxes to convert them. On conversions, you can withhold dollars to pay the tax bill, but Price suggests that if you have the cash, it could be better to skip withholding. This way, you won't have to sell any of your shares, giving you the maximum potential tax 'savings' if your stocks rally higher.

Of course, there are disadvantages to converting assets. Price writes:

"1. To get the maximum benefit you need to be able to pay the taxes due in the year following the conversion from a source other than the IRA which the shares came out of. If you need to withhold tax from the conversion amount you won't get the full effect that you can by paying separately.

Convert $100,000 in cash and withhold Combined Federal and State taxes at $33% combined and you'll only have $67,000 to rebound with, not $100,000.

2. If you choose bad stocks to convert, and they fall further or become worthless due to bankruptcy, you'll have wasted the tax money owed on their conversion.

That means moving only shares in which you have high conviction that they will ultimately be headed much higher. Risky, speculative names should probably not be in your Traditional IRA. If they are, leave them there, where the taxman can share in your loss if that is what happens."

The Smart Play

Roth IRA conversions can be tricky, so you'll want to ensure you do your homework and speak candidly about your financial situation with your lawyer and accountant.

Many overestimate their taxable income rate in retirement, so you'll want to objectively consider how likely your tax rate will climb after you retire. 

To do this, you'll want to calculate how much you'll earn in Social Security (if you file jointly, and your combined income is above $32,000, you'll pay some income tax on your benefits), if you'll work part-time, and if you'll have other sources of income, such a pension, and anticipated expenses.

It could be that after you've done the math, you discover your tax rate will be lower in retirement. Remember, income tax rates are progressive, so consider your effective tax rate (what you pay in taxes divided by your income) before determining if a conversion is right for you.

  • Roth IRAs offer tax-free growth and tax-free withdrawals in retirement.
  • Converting assets from a traditional IRA to a Roth IRA requires an upfront tax payment. Still, tax savings could be significant if your effective tax rate will be higher in retirement than it is today.
  • Declining stock values can mean you'll pay fewer taxes to convert your assets this year.
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