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For long-term investors, there is at least one silver lining to a stock market decline — the opportunity to potentially reduce their future tax liability by converting their pretax retirement savings to a Roth IRA.
Indeed, when you convert a traditional IRA or 401(k) to a Roth IRA, you pay taxes up front based on your portfolio value. If your portfolio is temporarily lower due to a stock market slump, the amount you owe will be less as well. With any luck, your portfolio will later recover and that growth will be tax-free.
That’s a big potential benefit for retirement savers, many of whom are facing a significant future tax bill when they begin taking mandatory withdrawals from their pretax accounts at age 72. (Required minimum distribution calculator)
“Most of our country saves for retirement in qualified plans, typically through their employer’s 401(k) or traditional IRA,” said Chad Tourin, president of Coastal Wealth’s Private Client Group in Ft. Lauderdale, Florida. “What they do not realize is that they will pay ordinary income tax on every dollar distributed from their accounts in retirement. This includes their contributions and compounding growth in the account that they deferred paying tax on over many years.”
What is a Roth IRA?
A Roth IRA is a retirement savings account that is funded with after-tax contributions. As such, contributions do not produce an income tax deduction, but earnings typically grow tax-free.
Other benefits of a Roth IRA include:
- There are no required minimum distributions from a Roth IRA.
- You may withdraw your contributions to a Roth IRA at any age without penalty if the account has been open at least five years. (Earnings would still typically be assessed an early withdrawal penalty if distributed before age 59½.)
No RMDs
Because Roth IRAs are funded with after-tax money, you are not required to take minimum distributions during your lifetime. That’s a major perk.
You may leave the savings in your Roth IRA untouched if you do not need it for living expenses, which permits those dollars to (hopefully) continue generating tax-free returns longer.
Earnings in a Roth IRA generally grow tax-free and penalty-free under the following two conditions:
- You withdraw those dollars after age 59½ .
- The account has been open for at least five years.
Note that the 10 percent penalty for an early withdrawal can potentially be avoided if you withdraw your earnings to pay for the purchase of a first-time home, college expenses, health care costs if you are unemployed, or the expenses related to the birth or adoption of a child.1
By contrast, RMDs on a 401(k) or traditional IRA must begin by age 73, and account owners must pay ordinary income tax on the amount distributed. Depending on their account balance, those RMDs can potentially push them into a higher tax bracket during retirement than they were in while working. (Learn more: 8 FAQs on Traditional vs. Roth IRAs)
Conversions give higher-income earners access to a Roth IRA
Roth IRAs can be a valuable retirement and estate planning tool. But many households are limited in how much they can contribute each year, and some are not eligible to contribute at all depending on their income.
For example, married couples filing jointly may contribute up to the annual limit ($7,000 for 2024, or $8,000 for those 50 and older) if their modified adjusted gross income is less than $230,000 for tax year 2024. Those making from $230,000 up to $239,000 may contribute a reduced amount, while married joint filers making $240,000 or more are not permitted to make contributions to a Roth IRA.2
That said, there are no income restrictions on Roth IRA conversions. Thus, they offer higher-income households that might otherwise be ineligible to contribute to a Roth IRA an opportunity to shift their savings into an after-tax account and potentially reduce their future tax liability. (Calculator: How much should I save for retirement?)
When to do a Roth IRA conversion - consider dollar-cost averaging
When stocks stumbled in the first half of 2022 amid interest rate and inflation fears, the call from investors to convert their pretax savings to Roth IRAs grew louder. But John Pearson, a financial professional with Barnum Financial Group in Shelton, Connecticut, urges caution.
Market timing of any kind, in which investors attempt to leverage stock market swings, often goes awry, he said, stressing that the safer choice for those committed to a Roth conversion is to move small amounts at a time.
“A lot of people say the perfect time to convert is when the stock market’s down, which means that the amount that you would convert to a Roth would be less, so your tax bill would be less,” he said. “That might be a great justification if we all felt that the market was going to go right back up again. If, however, the market sinks another 15 percent to 20 percent, then one might consider that to have been a bad idea.”
A safer bet, according to Pearson? Dollar-cost average your Roth conversions over a period of years rather than focusing on a single event like a stock market dip.
A more systematic approach to converting small amounts of your pretax retirement savings over time, as opposed to moving your entire traditional IRA or 401 (k) balance to a Roth IRA in a single year, could help minimize your tax exposure. (Learn more: Understanding dollar-cost averaging)
Remember that savings converted from a pretax account to a Roth IRA are taxed as ordinary income in the year you convert. Depending on how much you convert, that additional taxable income could bump you into a higher tax bracket for that year.
Those who do choose to convert often do so during the years after they retire, but before RMDs kick in from their pretax accounts at age 73, when their tax bracket may be temporarily lower.
Tourin notes that current tax rates make Roth conversions potentially more attractive now than they have been in the past or are likely to be in the future.
“Our tax rates and brackets have been relatively low in recent years, compared to historical norms,” he said. “This makes Roth conversions much more attractive because even if your income stays flat, it is likely the overall tax environment will be higher in the future, especially considering the government will need a way to recoup some of the stimulus money given out during the pandemic.”
Who should consider a Roth conversion?
Those who are temporarily in a lower tax bracket, either due to a drop in income or higher deductible expenses, are often considered to be the best candidates for a Roth IRA conversion. The income tax you pay, of course, is determined by your tax bracket. For the same reason, younger savers who expect their income to climb in future years may also benefit from a conversion. (Traditional vs. Roth calculator)
All things being equal, the younger you are during market downturns, the bigger the advantage to a Roth conversion because there will be less deferred gain to pay tax on in the year of conversion and more years to accumulate tax-free wealth in your Roth account, said Tourin.
You may also benefit from a Roth conversion if your goal is to leave as much money as possible to your heirs, he said. As noted, Roth IRAs do not require minimum distributions so your savings can continue to grow tax-free throughout your lifetime.
Remember, you need not convert all your pretax savings to a Roth IRA. Financial professionals say many households are better off maintaining a mix of both pretax and after-tax accounts.
Pretax accounts, including traditional IRAs and 401(k)s, offer immediate tax deductions, which helps to reduce your annual tax bill in the year you contribute.
“Ideally, in retirement you want to have a good mix of pretax retirement money and after-tax retirement money, as well as a pool of nonretirement-based assets so that you can make good choices as to where to take money from during retirement based on your tax situation each year,” said Pearson. “For instance, it might make sense to take your base income from your traditional IRA or 401(k) to pay your monthly bills, but take the money you need to buy a new car from the Roth because it’s tax free.”
It’s wise to consult a tax or financial professional for guidance.
Who should not consider a Roth IRA conversion?
Tourin makes clear that Roth IRA conversions are not ideal for everyone.
Those who expect their tax bracket to fall during retirement may be better off leaving their money in a traditional IRA or 401(k), where they can benefit from annual income tax deductions. Be aware, however, that many retirees underestimate their future tax rate. (Related: Traditional to Roth conversion: Should you?)
“If you believe you will be in a lower tax bracket in retirement, you might not want to do a conversion, but it’s important to consider what type of retirement you would like to live,” said Tourin. “If you plan to sit around and do nothing, you will probably be OK, because you will not need much income, but I always ask my clients this question: ‘What are your two most expensive days of the week now?’ Invariably, they answer Saturday and Sunday because the weekend is when they have time to do what they enjoy.”
Tourin follows with a second question: “If every day in retirement will be like a weekend, do you think you’ll need more or less money to live on?”
Understanding that concept, he said, is crucial to understanding the importance of tax-free distributions in retirement.
If you don’t project carefully, you may find you need bigger distributions from your pretax retirement accounts than expected, which could land you in the same or higher tax bracket you were in while working.
Conclusion
Market downturns may make Roth conversions more enticing, and some might benefit from a lower tax liability. But your income, tax bracket, portfolio balance, and legacy wishes also play a role in determining whether a mix of pretax and after-tax retirement savings are a better fit for you.
By working closely with a trusted financial professional, you can create a retirement savings strategy that helps you meet your financial goals.
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This article was originally published in July 2021. It has been updated.
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2 Internal Revenue Service, “401(k) limit increases to $23,000 for 2024, IRA limit rises to $7,000,” Nov. 1, 2023.