Is Now The Time for a Roth IRA Conversion?
With the recent implosion in domestic and international stock markets due to fears on what havoc the coronavirus will play on the world economy, investors are looking for any positives that could come out of this unprecedented violent and unusually fast equity market sell-off. Over the last couple of months, domestic stocks in the US are down in the area of 30% with the majority of world equity gauges off by similar or even greater amounts.
Most long-term investors (which you should be if you are investing in any retirement account) have a diversified portfolio that, outside of stock market investments, includes investments in bonds, real estate, commodities, alternatives and cash. Within an IRA, there is the one benefit of selling a portion of these products and rotating the proceeds into stocks when the equity markets have declined so significantly.
However, there is another ‘silver-lining’ to a dramatic stock market decline that many investors are not aware of: the Roth IRA conversion.
Simply put, a Roth IRA conversion allows investors to take their pre-tax traditional IRA and convert it into an after-tax Roth IRA. Of course, this strategy does come with one relatively large string attached: Roth IRA conversions require investors to pay income tax on the amount withdrawn from their IRA in the year the conversion takes place. This seems to go against any basic, common-sense tax planning: Pay more in income tax now instead of postponing the tax outlay and kicking-the-can-down-the-road. Does this make sense?
Yes, it definitely could, depending on your overall financial situation.
There are several reasons why a Roth IRA conversion makes absolute sense right now.
First, if your IRA portfolio was overweight stocks at the beginning of the year after the monumental stock market climb over the past 10-plus years and your portfolio was 60-70% (or gasp, higher) in stocks. More than likely, you’ve already experienced a decline of 25% or even more to start 2020. However, stock markets tend to come back quicker than they fall and if a cure for the coronavirus is found sooner than later, your IRA portfolio could rise very quickly. Converting your IRA to a Roth IRA would make all this potential gain (and of course future gain) completely free of income tax. Furthermore, the amount of tax you have to pay on an account that has a higher balance could be significant now when the equity markets have come down so much.
Second, if you have been laid off from your employment during this difficult time or anticipate a layoff coming and being out of work for several months or even until the end of the year, a Roth IRA conversion could be a smart decision. Unemployment means less income and of course less to pay in income tax. Therefore paying income tax now on your IRA balance when you may be out of work temporarily might make for perfect timing. Couple this with an investment portfolio that could be down 25% or more and this could be the opportune time. Just make sure that you keep a portion of the redirected funds set aside to pay the taxes due or have a separate stash set away for these type of outlays.
Third, your age. If you are a younger individual with 20, 30 or even more years until retirement, paying tax now on an IRA disbursement could be a wise move. Remember that unlike traditional IRA’s, Roth IRA’s have no required age when withdrawals must begin. In contrast, the IRS mandates that individuals begin withdrawing from their traditional IRA when they turn age 72. Roth IRA’s have no such restriction as the funds can be withdrawn at any time after age 59.5 (if your account has been open for a minimum of 5 years). As such, if you are younger and have a history of great family health and anticipate a career lasting late in life, Roth IRA distributions can be postponed after age 72. This would allow for several more years of tax-free compounding growth. With many of us living longer and healthier lives the option of postponing retirement, retirement investment withdrawals could very much be reality.
Fourth, what about future income tax rates? I believe anyone reading this article would be hard-pressed to say that income tax rates in the future will be less than they are now. In fact, in just as quick as 6 years income tax rates are already set to rise back to 2017 levels under the Tax Cuts and Jobs Act. As such, why not pay the tax now when rates are more than likely to be lower than they will be in the future? Another tidbit that could alter your financial planning down the road is if your social security payments will be taxed after exceeding a certain threshold. If you will be taking non-taxable distributions from a Roth IRA you are much less likely to end up paying tax on your Social Security benefits if you’re taking distributions from a fully taxable traditional IRA.
Fifth, if it’s relatively early in the year and any tax payable from an IRA disbursement is not even due until April 15th of 2021. This is a long time frame and could be even pushed farther out if the tax deadline in 2021 is delayed similarly as it is now for 2019 taxes (July 15, 2020). This would give one an opportunity to save up the required additional tax funds that need to be paid on any disbursement.
Of course, there are disadvantages to converting to a Roth IRA. Roth IRA’s need to be in place for 5 years before any tax-free withdrawals of earnings can be made, so if you have an emergency and need the funds during this time, a 10% tax penalty would be due on any earnings. If the economy goes into a full-on severe recession and you find yourself unemployed, some of the actual withdrawal may be needed to pay the income taxes due. Furthermore there is always the risk that stocks decline further and maybe you don’t ‘catch the bottom’ (which the majority of investors fail to do anyway).
A Roth IRA conversion can be a big move in your entire financial planning picture, especially if your IRA account balance is relatively high. This could result in a big tax bill next year and with the economy entering a period of instability, you want to make sure you have the career steadiness and necessary savings on hand to pay the taxes due. However, a conversion could be a great idea if you meet points 1-5 as outlined above. As always, everyone’s situation is unique to them and it’s best to talk with your personal investment advisor (and accountant, in this case) to see if a Roth IRA conversion is the best move for you.