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Clients have likely spent the past weeks monitoring the dramatic market downturn and worrying about the potential repercussions for their retirement income planning. While some recovery has already taken place, the drastic swings that occurred over the course of just a few days have highlighted a potential opportunity for capitalizing on the silver lining of a down market—the Roth IRA conversion.
Though a Roth conversion isn’t all about timing, paying attention to significant market swings can allow your clients to take advantage of benefits that, in some cases, can only be produced by careful timing—generating valuable results in the right circumstances.
Why Convert in a Downturn?
The primary reason to consider converting a traditional IRA to a Roth IRA in a market downturn involves the tax savings that such a move can generate. When a client converts an IRA to a Roth, he or she pays taxes on the entire value of the amount converted at his or her current ordinary income tax rates. Obviously, if the value of the IRA has declined (as is often the case in a market downturn), the client can convert the IRA assets at that lower value—generating a correspondingly lower tax liability.
If the market rebounds, the growth in the Roth assets will be tax-free to the client. After the Roth conversion, if the market continues to decline so that the value of the account assets dips lower than they were at the time of conversion, your client still has options. Fortunately, if the results of a Roth conversion are poor, the transaction can be reversed—“recharacterized”—as late as October 15 of the year following the initial conversion.
The client can choose to recharacterize only a portion of the Roth IRA, but the amount recharacterized must be transferred back to the traditional IRA in a trustee-to-trustee transfer (meaning that the client cannot receive a check for the funds transferred; they must be directly transferred to the IRA custodian). The client also must file an amended tax return reflecting the recharacterization by the October 15 deadline in order to reverse the tax liability under the conversion.
The client then has the option of executing another Roth conversion at the lower account value in order to generate even greater tax savings. If a Roth conversion is a move that a client is considering, paying attention to market fluctuations can be crucial to reducing his or her overall tax liability.
Other Roth IRA Considerations
Typically, it is advisable for a client to convert IRA funds to a Roth if he or she expects to be in a higher income tax bracket during retirement (or when the funds will be withdrawn). This often means that a Roth conversion is most valuable for a younger client who may be in a lower tax bracket today than after many years, after he or she has experienced a long and successful career.
Tax rates are almost certain to rise with time, so the more time the client has before retirement, the more likely it is that he or she will pay less in taxes on the IRA funds at today’s rates.
A client may also be interested in executing a current Roth conversion in order to reduce his or her future required minimum distributions (and the associated tax liability). Traditional IRAs are governed by rules that mandate withdrawals during the account owner’s life—Roth IRAs, on the other hand, are not subject to similar withdrawal requirements so that the funds may be left to grow indefinitely.
Whether or not a Roth conversion is appropriate for any given client must be analyzed in light of his or her individual situation—though a market downturn may make the strategy more advantageous from a tax perspective, it is important to consider the move in light of the client’s overall financial situation and long-term goals.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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