When stocks are down, there are not a lot of great things someone that’s invested can get excited about. However, there still can be big benefits of stocks being down.
One option would be to add more cash to stocks that are down to build up more shares for a rebound. Another option would be to make a conservative portfolio more aggressive. Another highlight of stocks being down is to convert Traditional IRA or 401k money into a Roth IRA. The first 2 ideas are strategies to take more risk with money. The goal of these strategies is making more money as stocks rebound. Doing a Roth IRA conversion is a tax strategy that works great when stocks are down.
How does a Roth IRA Conversion work?
An investor that has money in a Traditional IRA or 401k plan has money moved into a Roth IRA, creating a taxable event since the Traditional IRA or 401k plan is pre-tax. This means the money has never been taxed. There is no limit to how much someone can do when converting money from the pre-tax plan to the Roth IRA. The taxes can be withheld directly from the transfer of money or they can be paid separately when tax returns are filed.
What’s the benefit of doing a Roth IRA Conversion?
The reason for a conversion is to pay the tax now so that all the growth on the Roth IRA is tax free. In contrast, all the money in a Traditional IRA or Pre-tax 401k plan is taxed when it’s withdrawn in the future. This includes the growth. When stocks are down, this is especially a great opportunity because the account is down. Therefore, if all or part of a Traditional IRA is converted then, when stocks rebound, all that growth becomes tax free.
Who does Roth IRA Conversions make sense for?
There are a number of scenarios where it may make sense to convert a Traditional IRA into a Roth IRA.
For younger people, this can especially be a great strategy since they have more time to allow for growth on the account before needing to withdrawal the money. Paying the taxes now on a relatively smaller account size will likely save a lot of tax dollars in the future.
People that are nearing or in retirement are trying to lesser the burden of Required Minimum Distributions (RMDs), which currently start at age 72. At some point the IRS gets their money. RMDs are a percentage they make IRA owners take out each year to cause a taxable event. This forces those owners to pay the tax on the withdrawals. Converting ahead of time may make sense for some IRA owners to lessen the amount they would have to take for RMDs.
Make A Plan to Convert IRA into a Roth IRA
Some retirees, with significant amounts in IRA money, plan to pass most of that money to their kids. Non-spouse beneficiaries now have to take all the money out of an IRA within 10 years. This can be a major tax event for these beneficiaries, especially if there’s a large amount of money in the IRA and/or the beneficiary makes a good-sized income.
It can be better for the original IRA owner to make a plan to convert the IRA into a Roth IRA. Even though they would have to pay the tax, this may mean that the IRA money is taxed less if they are taxed at a lower rate than their beneficiary would be.