Is This the Time to Consider a Roth Conversion?

We’re all facing struggles right now related to the global pandemic. Some are trying to figure out how to co-work from home with a partner without driving each other crazy. Others have been furloughed or are experiencing a cut in pay. Many investors are also stressing about the drop in the market and what this means for their futures. However, like most situations, there is also a silver lining. Though looking at your retirement accounts right now might be a bit frightening, once you get past the initial shock, you’ll see there’s an opportunity. If you have money in traditional IRAs, taking this opportunity to convert them to Roth IRAs could save you some big money down the road. Here’s why.

The Difference Between Traditional IRAs and Roth IRAs

First, let’s take a quick look at the difference between these two investments. Traditional and Roth IRAs are both individual retirement accounts that you can put a limited amount of money into every year depending on your income and several other factors. With a traditional IRA, the money you put in is tax-free and you pay taxes on them when you take distributions from the account. Roth IRAs are the opposite: the money is taxed going in, but you withdraw it tax-free. Many investors have both traditional and Roth IRAs because they offer different types of advantages.

Your Roth distributions will eventually be a tax-free source of retirement income. If you convert to a Roth IRA in a year when you pay an unusually low tax rate, you can avoid getting hit with higher taxes when you take distributions in retirement.

Advantage of Roth IRAs in the Current Environment

We’ve talked about how flexibility will make you a better investor. Looking at your retirement accounts with your advisor and finding weaknesses and advantages related to the pandemic is a mark of an adaptable investor who responds to the environment rather than reacting out of fear. If you have traditional IRA accounts that can be rolled into Roth IRAs, you’ll be able to take advantage of the following:

Low Tax Rates

We as a country are paying historically low tax rates at the moment. That means when you convert to a Roth, you get to pay taxes now at the lower rates and can withdraw them later tax-free. It’s likely that the future will have much higher tax rates, so you’ll be saving a lot of money with this conversion.

Reduced Income

If you or your spouse has experienced a cut in pay, furlough, job loss, or had to take early retirement due to the pandemic, your income will be a lot lower this year. A lower income means a lower tax bracket and less tax on the amount of money you convert from your traditional IRA to a Roth. Take the following hypothetical into consideration: you and your spouse usually make a combined $100,000 a year. However, your spouse was furloughed and your combined income has dropped to $70,000. This will drop your tax bracket from 22% to 12%. If you do a conversion to a Roth, you’ll pay only 12% on taxes and will likely withdraw the money when you’re back in the 22% bracket (or higher.)

Stock Market Drop

If your portfolio is down, it makes a lot of sense to convert traditional IRAs to Roths. Let’s say you had $20,000 in a traditional IRA and after the pandemic-induced market turndown, it was reduced by 30%. You can now pay taxes on the remaining $16,000, convert the shares to a Roth, and buy the same $16,000 in shares inside the Roth. When the stocks rebound and your $16,000 turns back to $20,000, you’ll experience tax-free growth. You’ve essentially paid taxes on a reduced share price and can withdraw the money that has grown down the road without paying any taxes on it.

Those who have a low-risk tolerance when it comes to investing may be tempted to hunker down and wait out the storm, hoping their investments will rebound when circumstances improve. But if you do this, you ignore a huge opportunity to diversify your portfolio and increase your tax-free investments. Have questions about converting traditional IRAs to Roths right now? Please leave them below!