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Retirement

Why a Down Market May Be the Best Time for a Roth IRA Conversion

When the stock market drops, many investors feel anxious. But for those considering a Roth IRA conversion, a downturn may offer a unique opportunity to reduce taxes and grow assets more efficiently.

A Roth IRA conversion involves moving funds from a traditional IRA or other pre-tax retirement accounts into a Roth IRA. While you pay taxes on the converted amount, all future growth and qualifying withdrawals from the Roth account are tax-free. The key advantage during a market downturn is that you’re converting at a lower value, which means a smaller immediate tax burden.

For example, if your traditional IRA was worth $100,000 but drops to $65,000 during a downturn, converting now means paying taxes on $65,000 rather than $100,000. If the market recovers inside the Roth, all that future gain is tax-free.

Who Should Consider a Roth Conversion

Roth conversions are particularly valuable for high earners who exceed Roth IRA income limits. In 2022, individuals earning more than $144,000 and married couples earning more than $214,000 could not contribute directly to a Roth IRA. A conversion allows these individuals to bypass that restriction by contributing to a traditional IRA and converting it later.

Conversions can also benefit younger investors with a long time horizon, or near-retirees who want to reduce the size of their required minimum distributions (RMDs) from traditional accounts.

Key Considerations Before Converting

Although the benefits can be significant, there are important factors to evaluate:

The Pro-Rata Rule
If you have both pre-tax and after-tax dollars in any IRA accounts, the IRS treats all of your IRAs as one combined account. You can’t convert just the after-tax portion. Instead, the tax owed will be based on the proportion of pre-tax to after-tax funds across all accounts.

The Five-Year Rule
Converted funds must remain in the Roth IRA for five years before you can withdraw them without penalty. This rule applies regardless of your age. The five-year period begins on January 1 of the year you complete the conversion. If you’re planning to retire or need funds within that time, you’ll need other assets available.

Impact on Medicare Premiums
A large Roth conversion can increase your adjusted gross income, which may lead to higher Medicare Part B and D premiums in future years. For instance, a higher income in 2022 could affect your premiums in 2024 due to the two-year income lookback period.

Take a Strategic Approach

The benefits of a Roth IRA conversion depend on your specific financial and retirement situation. A conversion done at the right time can lead to long-term tax savings and increased flexibility in retirement. However, it requires careful analysis of your current tax rate, future tax outlook, and overall income.

Before converting, consult with a qualified financial advisor or tax professional. They can help you determine whether a conversion fits into your retirement plan and guide you through the timing, tax impact, and long-term benefits.

A market downturn may seem like the wrong time to make changes—but in the case of a Roth IRA conversion, it could be one of the smartest financial decisions you make.

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