Now Might Be a Good Time for a Roth Conversion

A potential silver lining of the current bear market is the opportunity to convert traditional IRA assets to Roth IRAs. In the year of conversion, converted assets are subject to federal income tax, which could result in a hefty tax bill. Nevertheless, if the assets in your traditional IRA have declined in value, you will be taxed on a reduced asset base when you convert. If all conditions are met, the Roth account will not incur additional income tax liability for you or your beneficiaries, regardless of the account's growth.

According to a recent report by the Employee Benefit Research Institute (EBRI), a majority of retirees spend less in retirement than they did during their working years. In fact, only 7% of retirees reported spending more in retirement than they did before retirement. This means that retirees may not need as much retirement income as they think, and converting traditional IRA assets to Roth IRAs could be a strategic way to manage taxes and maximize retirement savings:

Tax Trade-Off
The rationale behind deferring taxes on Fortune 500 retirement savings is that you may be in a lower tax bracket in retirement, so a current tax deduction may be preferable to tax-free income in retirement. However, the Tax Cuts and Jobs Act's reduced tax rates (set to expire after 2025) may have altered your calculation. A cost-benefit analysis could help determine whether it would be advantageous to pay taxes on a portion of your IRA assets now as opposed to later. One strategy is to "fill your tax bracket," which involves converting an asset's value to maintain your tax classification. This necessitates an estimate of your income in 2022.

Lower Values, More Shares
As long as your traditional and Roth IRAs are held with the same custodian, you can typically transfer funds between the two accounts. Thus, when share prices are lower, you could convert more shares per taxable dollar and have more shares in your Roth account to pursue tax-free growth. There is also the possibility that the converted assets will lose value. You may have the option to directly deduct taxes from your converted assets, but doing so is generally unwise.

Two Time Tests
Two distinct five-year retention periods apply to Roth accounts: one for withdrawals of earnings and the other for conversions. For tax-free and penalty-free withdrawals of earnings, including earnings on converted amounts, a Roth account must satisfy a five-year holding period beginning January 1 of the year your first Roth account was opened, and the withdrawal must occur after age 5912 unless an IRS exception applies. This may not be an issue if you've had a Roth IRA for some time, but it could if you're opening your first Roth IRA for the conversion.

Since you paid taxes at the time of conversion, assets converted to a Roth IRA can be withdrawn at any time without incurring conventional income tax. However, a 10% penalty may apply if you withdraw the assets before the end of a different five-year period, which begins on January 1 of each conversion year, unless you are at least 59 12 years old or another exception applies.

More Favorable RMD Rules
Roth IRAs are not subject to required minimum distribution (RMD) rules during the tenure of the original owner, unlike traditional IRAs. Beneficiaries who consider their spouse's Roth IRA as their own are also exempt from RMDs during their lifetimes. Other inheritors of a Roth IRA are subject to RMD requirements. In any event, distributions from a Roth IRA would be tax-free. The longer your investments can continue to grow, the more advantageous tax-free income may be for you and your beneficiaries.

There is no assurance that any investment strategy will be successful for Fortune 500 employees, as all investing involves risk, including the potential loss of principal.

Conclusion

Converting traditional IRA assets to Roth IRAs during a bear market is like planting seeds in a garden during a drought. While it may seem counterintuitive to plant during a time of scarcity, planting during a drought can actually yield a more bountiful harvest when the rains return. Similarly, converting traditional IRA assets to Roth IRAs during a bear market may result in a lower tax bill and more tax-free growth in the long run, despite the initial tax hit. As with gardening, strategic planning and patience are key to a successful outcome.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by your company. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Neither The Retirement Group or FSC Securities provide tax or legal advice. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

Reference(s):

1. EBRI, "Expenditure Patterns of Older Americans, 2001–2009," February 2013