Hi all
With the market down turn, my traditional IRA has lost value. I am thinking this might be a good opportunity to convert it to Ross IRA so that if the market turns up, I could save some money on tax.
I wonder if some of you have done this and do you have some advice as to what are the things - pros and cons - to consider?
Thank you very much.
-M
With the market down turn, my traditional IRA has lost value. I am thinking this might be a good opportunity to convert it to Roth IRA so that if the market turns up, I could save some money on tax.
There, fixed that for you.
Yes, converting to a Roth IRA when stock prices have dropped will cost you less in taxes than it would have if you had converted before they dropped.
I wonder if some of you have done this and do you have some advice as to what are the things - pros and cons - to consider?
You need to be aware that this will be additional ordinary income on top of any other income that you have, so it will be taxed at your marginal rate, and depending on how close you are to the top of your current bracket and the size of the conversion, some of the conversion could be pushed into a higher bracket.
You are basically doing tax arbitrage between what paying taxes now vs. paying taxes later will be. You need to evaluate what the tax rate for your conversion will be vs. what you expect withdrawals from your IRA to be in retirement. If the current tax rate is higher than you expect the retirement withdrawals to be, you will probably come out on the wrong end of the arbitrage.
You need to be able to pay the taxes (including any applicable state taxes) from funds other than the IRA, especially if you are under 59 1/2. Any taxes withheld from the IRA are subject to early withdrawal penalties. Even if you’re over 59 1/2, you need to consider if it’s worthwhile to pay taxes out of the account, since you will be reducing your balances for retirement.
Assuming your other income in 2022 is similar to your 2021 income, you will owe more in taxes by doing a conversion in 2022. Be sure that you meet a safe harbor so that you will not owe underpayment penalties. If you are working, you may want to increase your withholding to account for the extra taxes you will owe.
Your Roth IRA must have been open and funded for at least 5 years in order to take tax and penalty-free (qualified) distributions even after you reach 59 1/2. Before that, you can only take original contributions and conversions that were at done at least 5 years prior without being subject to taxes and penalties.
Don’t forget about state taxes if you live in a state that taxes Roth conversions.
AJ
Yes, converting to a Roth IRA when stock prices have dropped will cost you less in taxes than it would have if you had converted before they dropped.
While AJ’s answer is very thorough, as always, I’d like to expand the response re: the OP’s question specifically about taking advantage of the market drop. Clearly there are caveats, but if one can fund the tax bill, whatever it is, this market has beaten up certain investing styles/portfolios way worse than the market cap weighted indices are down. For example, growth investors have seen sharper drawdowns, which history tells us are likely to rebound stronger than the market averages once today’s macro issues give way to more favorable conditions and the next cycle of optimism begins. Paying taxes on an oversold IRA portfolio now to convert it to a Roth that will potentially have outsized returns (starting from depressed values) has a good chance to be more advantageous than staying the course. (I could expand my thoughts using numbers but will hold off, assuming the above is clear?)
So, to me it somewhat depends on what you own and are converting. If your IRA holds index funds with expectations for market performing returns, then I too see conversion as all about tax arbitrage. But if you think your current holdings may be oversold and are due for a nice bounce in the next market recovery, I’d strongly consider converting.
…But if you think your current holdings may be oversold and are due for a nice bounce in the next market recovery, I’d strongly consider converting.
That was precisely my thinking in deciding to convert the GOOG in my TIRA now. Thanks for the validity check!
AJ
Thank you very much for the advise. I am already retired and so I don’t have much regular income, and I do not see a future time when my tax rate might be lower. I do have interest income and capital gains. Conversion is going to lift my tax for sure. But my thinking is that the money I convert into Roth may appreciate and may more than offset the tax I pay at the time of conversion. I will do more research. At this point my understanding is that there is no limit as to how much I can convert and how often I can convert. If I am correct, I can convert some amount this year, and convert some more next year so that the tax rate do not shoot up too much.
Thanks and have a good weekend.
-M
But my thinking is that the money I convert into Roth may appreciate and may more than offset the tax I pay at the time of conversion. I will do more research.
Whether your money is better off converted into a ROTH than in a traditional IRA all comes down to tax rates. That assumes you invest the same way in the ROTH as in the IRA. In the IRA it grows bigger and then gets taxed on the larger sum. In the ROTH the smaller, post-tax balance grows, but if the tax rates are the same it all ends up the same. However if the tax rates differ, so do the results. If you convert all of it at once you have to pay the taxes all at once, which could put you into a higher tax bracket.
What I have been trying to do each year is convert enough to just about reach the top of my current tax bracket without going over.
In the ROTH the smaller, post-tax balance grows
This implies that you pay tax using the IRA money. If you can pay tax using other funds than the IRA fund, you would have some advantage. I think.
-M
This implies that you pay tax using the IRA money. If you can pay tax using other funds than the IRA fund, you would have some advantage. I think.
-M
It all depends on your rate of return, your current tax rate and future tax rates. Perfection isn’t possible. All you can do is make the best decision with available information.
In the ROTH the smaller, post-tax balance grows
This implies that you pay tax using the IRA money. If you can pay tax using other funds than the IRA fund, you would have some advantage. I think.
No. It only seems that way because you’re looking at the retirement funds in isolation. If you pay the tax using funds outside of the IRA money, you’ve reduced your non-retirement assets. Your total assets (retirement plus non-retirement) will be the same regardless of what you choose to do (assuming constant tax rates throughout).
Ira
I am already retired
I would again point out that if you have not had a Roth IRA open for at least 5 years, even if you are over 59 1/2, you will be subject to the ordering rules in IRS Pub 590-B https://www.irs.gov/pub/irs-pdf/p590b.pdf that can impose taxes and penalties on withdrawals of converted amounts if the conversion is less than 5 years old. So, unless you have already had a Roth IRA open and funded for 5 years, be sure that you are only converting amounts that you won’t need until your Roth is at least 5 years old.
Note - the reason I am pointing this out again is that you incorrectly referred to these accounts as “Ross IRAs” which leads me to believe that you may not already have one open.
AJ
Whether your money is better off converted into a ROTH than in a traditional IRA all comes down to tax rates. That assumes you invest the same way in the ROTH as in the IRA. In the IRA it grows bigger and then gets taxed on the larger sum. In the ROTH the smaller, post-tax balance grows, but if the tax rates are the same it all ends up the same. However if the tax rates differ, so do the results. If you convert all of it at once you have to pay the taxes all at once, which could put you into a higher tax bracket. - RHinCT
What you say is true, the math makes the tax paid the same if rates stay the same.
But, big but, what will be different is the timing of those taxes. With Roth conversions, you have control over WHEN those taxes are paid. By spreading the tax bite out as Roth conversions over several years, you will reduce future RMD’s. And based on the size of the TIRA, and other income, those RMD’s may push you into IRMAA penalty land.
So even though the taxes may be the same, avoiding the IRMAA penalty could very well save money over all. Food for thought.
PS - IMHO, it is better to leave your heirs a tax free Roth Account than saddling them with taxes on an inherited TIRA.
PS - IMHO, it is better to leave your heirs a tax free Roth Account than saddling them with taxes on an inherited TIRA.
Feel free to saddle me with the taxes from inheriting your TIRA. I will happily pay the taxes on that inherited TIRA.
I don’t actually expect anyone to take me up on this offer - but it I am not being sarcastic, I truly will be happy to inherit anyone’s TIRA and pay the taxes that causes.
Hopefully this does make it clear that any heirs should be happy to get either a TIRA or a Roth IRA - if they get a Roth IRA, the taxes have been paid, BUT the amount they’re getting would be smaller than if that had been invested in thee same way in a TIRA account.
And IMO getting a Roth IRA that is worth $40k is the same as getting a TIRA account that’s worth $50k that you’re paying 20% taxes on.
So it’s still a matter of what is the tax rate when potentially converting to Roth vs. tax rate later on - If the heirs will have a 24%+ tax rate, but your tax rate when converting to Roth is 12%, it makes sense to convert to Roth. OTOH, if the heirs will have a 22% rate, but you currently have a 35% rate, it doesn’t make sense to convert to Roth.
What you say is true, the math makes the tax paid the same if rates stay the same.
Except, under current law, the rates are scheduled to go up in 2026. The 22% bracket will go up to 25% and the 24% bracket will become the 28% bracket. So if you believe that Congress will be unable to extend the TCJA rates, converting into the 24% bracket could make sense if you expect to be in the 25% bracket in 2026.
AJ
Feel free to saddle me with the taxes from inheriting your TIRA. I will happily pay the taxes on that inherited TIRA.
I don’t actually expect anyone to take me up on this offer - but it I am not being sarcastic, I truly will be happy to inherit anyone’s TIRA and pay the taxes that causes.
Hopefully this does make it clear that any heirs should be happy to get either a TIRA or a Roth IRA - if they get a Roth IRA, the taxes have been paid, BUT the amount they’re getting would be smaller than if that had been invested in thee same way in a TIRA account.
Providing the estate doesn’t have to pay estate taxes. The current estate exemption amount expires in a few years.
Note - the reason I am pointing this out again is that you incorrectly referred to these accounts as “Ross IRAs” which leads me to believe that you may not already have one open.
AJ
Maybe the original poster’s name is “Ross”.
One thing to remember is that Roth IRAs are not subject to RMDs for the original account holder, while traditional-style retirement accounts are. If you project having a large enough balance across your Traditional retirement accounts to where your RMDs will be larger than what you need to take out to support your lifestyle, then early Roth conversions may make sense to help you manage the timing of your income to avoid bracket and other tax/income related cost creep later in your retirement.
We have a progressive tax system, not a flat rate one. We also have income-related triggers in the rules that retirees face such as Social Security benefits getting taxed, income-tested Medicare Part B premiums, as well as Medicare-related taxes on non-earned income once it gets high enough. Those triggers reward strategies that manage the timing of income, even if all else is largely equal.
In addition, RMDs are potentially doubly progressive from a tax perspective. They are larger portions of your account balance as you age, and if your account balance grows over time despite those withdrawals, that becomes a larger base upon which the RMDs must be taken.
Of course, those considerations matter most for people with decent asset bases who live long and healthy lives. May we all be so fortunate!
Regards,
-Chuck
Home Fool
The current estate exemption amount expires in a few years.
Can you please elaborate on that?
Thanks!
One thing to remember is that Roth IRAs are not subject to RMDs for the original account holder, while traditional-style retirement accounts are.
but ROTH 401Ks are subject to RMDs
Can you please elaborate on that?
Thanks!
In 2022, the estate exemption is $12M with the ability of a surviving spouse to file to port the unused portion of the deceased spouse’s estate and gift tax exemption. In 2026, the estate exemption drops to $6.4 million. Still enough for most but a consideration for those with larger estates.
In 2026, the estate exemption drops to $6.4 million.
This is another provision of the TCJA that expires in 2026, along with the aforementioned bracket changes. Congress may, or may not, be able to extend the TCJA.
AJ