Stock Market Slump May Be a Good Time for a Roth Conversion

By Clifton Linton
Senior Writer, mPower

In This Story Save on Taxes Rules An Alternative

This year's stock market declines may be a blessing in disguise for long-term savers. If your traditional IRA is invested in equities, the time may be ripe to convert it to a Roth IRA before the Dec. 31 deadline.

By converting when the value of your account is down, you may pay less tax than if the market were surging.

minute: read this article at a glance.

Technical Terms Lump sum Modified adjusted gross income (MAGI) Roth conversion

The main selling point for Roth IRAs is that withdrawals are tax-free (because contributions to the account are made on an after-tax basis). Further, you can pass on a Roth to your heirs and they won't have to pay income tax on the withdrawals either.

But, those selling points may mean nothing to you if the bulk of your retirement savings are in a traditional IRA: converting a traditional IRA to a Roth can be a costly proposition.

Save on Taxes

This year's weak stock market may be the answer aspiring converters have been waiting for, says Certified Financial Planner Neil Downing, author of Maximize Your IRA.

"It seems to me that if you have an IRA that's invested in tech stocks, that got hammered, you can either hang your head and be sad or see it as an opportunity to convert," said Downing.

Here's how it works: When you convert a traditional IRA to a Roth IRA, you must pay income tax on your original contributions as well as any return on those contributions. If the value of your traditional IRA has declined, your profits, and possibly even your initial contributions, will be lower and so will your taxes. "It'll now cost you less to convert," Downing said.

"It seems to me that if you have an IRA that's invested in tech stocks, that got hammered, you can either hang your head and be sad or see it as an opportunity to convert." — Neil Downing, author of Maximize Your IRA.

He offered this example: Suppose you earned enough annual income to be in the 28 percent tax bracket and your IRA was worth $10,000 at the beginning of the year. If you converted at that time, your tax bill on the conversion would have been $2,800. But, if the value of your IRA fell to $5,000 at the end of the year, your taxes would only run $1,400.

A Roth conversion may be particularly appealing to young savers who will have plenty of time for their account balances to compound and make up for the tax hit, said Downing.

Rules

There's still a catch. You need to pay all the taxes on the conversion by the time you file your tax return for the year. When the Roth IRA was introduced in 1998, it was possible to spread the taxes over four years — but that was a one-time offer that expired in 1999. Now, you have to pay the conversion taxes all at once.

Also, you can't convert in a year when your modified adjusted gross income is over $100,000. That limit is the same whether you are single or married filing jointly. If you are married filing separately, you may not convert to a Roth.

The deadline for converting a traditional IRA to a Roth IRA is Dec. 31.

An Alternative

For those worried about a big tax bite, there may be a more palatable solution that doesn't require a down market. You can convert your IRA using a technique known as reverse dollar-cost averaging, said Certified Financial Planner Robert Kailes, of Playa del Rey, Calif. In other words, you convert the account using periodic withdrawals.

Here's an example of how it works, assuming you're single and you don't itemize on your tax return, and that we're excluding the impact of the market and state taxes on your investment:

Suppose your traditional IRA is worth $50,000. If you earn $50,000 a year, a lump sum conversion would boost your adjusted gross income another $50,000, pushing you up into the 31 percent tax bracket from the 28 percent bracket. Excluding state taxes, and assuming single filing and no itemizing, you would owe $14,900 in taxes on the $50,000 you converted.

Now, suppose you decided instead to convert the IRA in chunks of $10,000 a year over five years. Further, let's assume that your investment value remains stable. The consequences of this strategy are that you remain in the 28 percent tax bracket, so your total conversion tax, excluding state tax, would only be $14,000 ($2,800 per year).

Kailes adds that reverse dollar-cost averaging will "smooth out" the conversion prices. Each time you sell a part of your IRA portfolio, you are selling it at a different price. This ultimately creates two things: a more manageable tax bite each year and a better average conversion price.

For example, suppose you hold 100 shares of stock in your IRA, currently priced at $100 a share. If you sold 25 shares at $100 a share this year, 25 shares at $80 next year, 25 shares at $60 the following year, and the final 25 shares at $40 the fifth year, your average selling price would be $70 a share. Similarly, if prices rose and you sold 25-share blocks at $100, $120, $140 and $160 a share, your average selling price would be $130 a share. You wouldn't be selling at the high or low in either case but you would get a better average price.

Related Reading Converting Your Traditional IRA into a Roth IRABCs: The Rules of Conversions

However, if the market starts to rally, this strategy has a possible downside because that would mean converting a larger account balance. "But, the upside is that you don't have to take it all at once. You have more control," Kailes said. What's more, if the market continues to slump, you may pay even less tax in subsequent years. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Stock Market Slump May Be a Good Time for a Roth Conversion

By Clifton Linton
Senior Writer, mPower

In This Story Save on Taxes Rules An Alternative

This year's stock market declines may be a blessing in disguise for long-term savers. If your traditional IRA is invested in equities, the time may be ripe to convert it to a Roth IRA before the Dec. 31 deadline.

By converting when the value of your account is down, you may pay less tax than if the market were surging.

minute: read this article at a glance.

Technical Terms Lump sum Modified adjusted gross income (MAGI) Roth conversion

The main selling point for Roth IRAs is that withdrawals are tax-free (because contributions to the account are made on an after-tax basis). Further, you can pass on a Roth to your heirs and they won't have to pay income tax on the withdrawals either.

But, those selling points may mean nothing to you if the bulk of your retirement savings are in a traditional IRA: converting a traditional IRA to a Roth can be a costly proposition.

Save on Taxes

This year's weak stock market may be the answer aspiring converters have been waiting for, says Certified Financial Planner Neil Downing, author of Maximize Your IRA.

"It seems to me that if you have an IRA that's invested in tech stocks, that got hammered, you can either hang your head and be sad or see it as an opportunity to convert," said Downing.

Here's how it works: When you convert a traditional IRA to a Roth IRA, you must pay income tax on your original contributions as well as any return on those contributions. If the value of your traditional IRA has declined, your profits, and possibly even your initial contributions, will be lower and so will your taxes. "It'll now cost you less to convert," Downing said.

"It seems to me that if you have an IRA that's invested in tech stocks, that got hammered, you can either hang your head and be sad or see it as an opportunity to convert." — Neil Downing, author of Maximize Your IRA.

He offered this example: Suppose you earned enough annual income to be in the 28 percent tax bracket and your IRA was worth $10,000 at the beginning of the year. If you converted at that time, your tax bill on the conversion would have been $2,800. But, if the value of your IRA fell to $5,000 at the end of the year, your taxes would only run $1,400.

A Roth conversion may be particularly appealing to young savers who will have plenty of time for their account balances to compound and make up for the tax hit, said Downing.

Rules

There's still a catch. You need to pay all the taxes on the conversion by the time you file your tax return for the year. When the Roth IRA was introduced in 1998, it was possible to spread the taxes over four years — but that was a one-time offer that expired in 1999. Now, you have to pay the conversion taxes all at once.

Also, you can't convert in a year when your modified adjusted gross income is over $100,000. That limit is the same whether you are single or married filing jointly. If you are married filing separately, you may not convert to a Roth.

The deadline for converting a traditional IRA to a Roth IRA is Dec. 31.

An Alternative

For those worried about a big tax bite, there may be a more palatable solution that doesn't require a down market. You can convert your IRA using a technique known as reverse dollar-cost averaging, said Certified Financial Planner Robert Kailes, of Playa del Rey, Calif. In other words, you convert the account using periodic withdrawals.

Here's an example of how it works, assuming you're single and you don't itemize on your tax return, and that we're excluding the impact of the market and state taxes on your investment:

Suppose your traditional IRA is worth $50,000. If you earn $50,000 a year, a lump sum conversion would boost your adjusted gross income another $50,000, pushing you up into the 31 percent tax bracket from the 28 percent bracket. Excluding state taxes, and assuming single filing and no itemizing, you would owe $14,900 in taxes on the $50,000 you converted.

Now, suppose you decided instead to convert the IRA in chunks of $10,000 a year over five years. Further, let's assume that your investment value remains stable. The consequences of this strategy are that you remain in the 28 percent tax bracket, so your total conversion tax, excluding state tax, would only be $14,000 ($2,800 per year).

Kailes adds that reverse dollar-cost averaging will "smooth out" the conversion prices. Each time you sell a part of your IRA portfolio, you are selling it at a different price. This ultimately creates two things: a more manageable tax bite each year and a better average conversion price.

For example, suppose you hold 100 shares of stock in your IRA, currently priced at $100 a share. If you sold 25 shares at $100 a share this year, 25 shares at $80 next year, 25 shares at $60 the following year, and the final 25 shares at $40 the fifth year, your average selling price would be $70 a share. Similarly, if prices rose and you sold 25-share blocks at $100, $120, $140 and $160 a share, your average selling price would be $130 a share. You wouldn't be selling at the high or low in either case but you would get a better average price.

Related Reading Converting Your Traditional IRA into a Roth IRABCs: The Rules of Conversions

However, if the market starts to rally, this strategy has a possible downside because that would mean converting a larger account balance. "But, the upside is that you don't have to take it all at once. You have more control," Kailes said. What's more, if the market continues to slump, you may pay even less tax in subsequent years. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.