We often think of market downturns as bad things, but we can also reap some benefits from the situation. In particular, this might be the right time to pursue tax-saving opportunities such as a Roth conversion.
What is a Roth conversion? When you first established your retirement account, you choose between a traditional or Roth structure. Traditional retirement accounts allow you to contribute pre-tax dollars to a retirement fund, and delay paying income taxes on that money until you begin taking withdrawals in retirement. That means, each year that you withdraw funds from the account, you owe taxes on the money as regular income.
On the other hand, a Roth account allows you to save post-tax dollars in a retirement account but enjoy tax-free withdrawals in retirement.
A Roth conversion is possible when you convert a traditional retirement account to a Roth account, pay some taxes on the rollover upfront, but then enjoy tax-free withdrawals for the rest of the account’s lifetime.
Timing is everything. When you convert a traditional account to a Roth account, the funds converted are treated as if you withdrew it. It is added to your regular income for the year, you pay income taxes on the funds, and then the money is deposited into a Roth account to grow tax-free from now on.
Let’s assume that, due to a market downturn, your traditional retirement account has lost value. The expectation, of course, is that the account will rebound and regain its value as the market improves. But if you roll the funds into a Roth account now, you can convert to a tax-free status while your assets are essentially worth less. Then, as the market improves, you will enjoy all of the benefits of a Roth account.
And finally, your future withdrawals during retirement will be tax-free as well!
So, for some people, a market downturn presents the perfect opportunity to perform a Roth conversion. But it’s not the right choice for everyone. Let’s discuss this option in more detail at our next meeting, and we can help you learn what to expect from a Roth conversion.