Why a Roth Conversion Now?

Transcript: 

Hey guys, Mike Frontera here back with another Retirement Theory Video. So if you watch my videos for any length of time, you know I have great love and reverence for the Roth IRA. And now with many areas of the market down over 20%, we look to the Roth IRA to help us turn lemons into lemonade! How so? With a Roth Conversion, of course!

OK, let’s take a quick moment to bring everyone up to speed on the basics. The gist of a Roth IRA is that it is an account in which you invest after-tax money, in other words no deduction, and in turn it can provide you with tax-free growth and withdrawals in retirement. A Traditional IRA, or just IRA, works the opposite- and it’s what most of us are familiar with. You generally contribute pre-tax money, but your withdrawals in retirement are considered taxable income.

Now you perform a Roth conversion, you are choosing to pay the tax now on your IRA to convert it to a Roth where, assuming qualified withdrawals, all of the future growth becomes tax-free. Now considering that you can convert your pre-tax IRA to Roth in any amount and any year you choose, there are times when a strategic conversion can make a lot of sense.

So, why might a conversion make sense while the market is down? Basically to get the money out of those pre-tax retirement accounts as cheaply as possible. Remember, when you contributed to your 401(k), 403(b) and IRA on a pre-tax basis, you basically postponed paying the tax bill on the amount you contributed. So eventually you, or maybe one of your beneficiaries, are required to pay that tax bill to get the money out of those accounts so that they can use them.

If we assume that the market eventually recovers, as it has with every other downturn in history, then wouldn’t it make sense to pay the tax bill while share prices (and thus the taxes) are low. To borrow the investing adage of buy low and sell high….performing a Roth conversion in a down market is pay low and spend high.

Alright, let’s look at an example of how this might work:

So here’s Jerry. He is in the 22% Federal tax bracket and expects to be in the same tax bracket for the rest of his life.

Let’s say Jerry owns 500 shares of ABC Corp. stock (that’s not a real stock) in his Traditional IRA. ABC is trading at $100 per share, so he has $50,000 of ABC Corp. A few months later, Jerry notices ABC Corp. is now trading 30% lower at $70 a share. So Jerry decides to convert half of his ABC shares to his Roth IRA.

Assuming that 22% tax rate, his Federal tax on the conversion would be:

22% * 250 shares * $70 = $3850

So Jerry pays $3850 in tax and now his 250 shares are in his Roth. Had he converted those shares while they were trading at $100, the Federal tax would be

22% * 250 * $100 = $5500

In both cases he ends up with half of his shares in pre-tax IRA and half in Roth, but performing the conversion while share prices were down knocked his tax bill down from $5500 to $3850!

Now the big assumption you must make here is that the share price eventually recovers. Assuming it does, that recovery is allowed to occur tax-free in the Roth. Had the conversion never occurred, not only would the share price recover, but your tax bill would too.

Now like most things in retirement planning, there are terms and conditions to deal with and just the fact that the market is down does not necessary mean everyone should be performing these conversions. Your age, income, beneficiaries, time before withdrawals, and your ability to pay the taxes out of pocket, among other factors need to be considered. You must also be aware of restrictions, including the 5-year waiting rule for converted funds to be available for your qualified withdrawals, before pulling the trigger. Finally, note that Roth recharacterizations, (basically the undo option) for conversions is no longer available.

So, do you have questions for me? Come visit me at www.retirementtheory.com or send me an email at mike@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we’ll see you next time.