Why a Roth IRA Transfer Makes Sense Now | Smart Change: Personal Finance

(Sam Swenson, CFA, CPA)

With broad market indices down in double digits since the start of the year, it makes sense to think about how to make the most of the situation. Downturns in the market can provide opportunities for tax planning, and it’s at least useful to explore what some of these strategies might look like.

One of the best techniques to use during a market downturn is the Roth transformation. In short, a Roth transfer involves moving money from a pre-tax retirement account (usually a traditional IRA) to a Roth IRA, which is a tax-exempt retirement account. In other words, by shifting assets from a “pre-tax” state to a “tax-free” state, you’re voluntarily paying taxes now on a zero tax bill for the rest of your life. Needless to say, this might sound like an attractive option.

Below, we will discuss how to implement this in practice and what to consider before converting.

How does a Roth IRA work?

A Roth IRA is a retirement account that allows an investor to invest and grow retirement money tax-free. Crucially, money in a Roth IRA has already been taxed, which is the mechanism that allows a Roth IRA to operate as is. Once the assets become in a Roth IRA — and various holding period requirements are met — they will be exempt from income tax forever.

When you convert a traditional IRA to a Roth IRA, it’s very different from Contribute Money for a Roth IRA. The contribution is limited to $6,000 per year ($7,000 if you are over 50) and subject to various IRS income limits. On the other hand, the conversion is unlimited. However, you will be responsible for a huge tax bill if you are not strategic about it How do And when You perform the conversion.

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What does the Roth conversion look like in practice?

This is the part that can get a little technical for people, but it can be simplified with an example. A good first step in performing a Roth conversion is to add the estimated conversion value to your file Expected total income for the year. This means adding your salary, independent income, investment income, and any other income you have with the potential Roth transfer amount.

If you have, say, $100,000 in gross income and are considering transferring $25,000 in assets from a traditional IRA to a Roth IRA, your projected gross income for the year is $125,000. If you’re a single individual, that puts you, according to the 2022 federal tax brackets, in a 24% marginal tax bracket. This means that the cost of converting a Roth is simply 24% times $25,000, or $6,000.

You’ll pay $6,000 in tax for the current year in return for never having to pay tax again on the $25,000 you transferred. Since this tax credit includes all growth and profits (possibly for many decades), this can be a really tempting trade-off.

How can a market downturn lower costs?

Imagine the same scenario as above, but instead assume that due to a market downturn, the value of your traditional IRA drops from $25,000 to $15,000. By following the same formula above, you’d add $15,000 to $100,000 to come to $115,000 in projected total income for the year. Since you’re still in the 24% marginal tax bracket for federal taxes, you’d multiply $15,000 by 24% to arrive at your conversion cost: $3,600.

Either way, you’ll transfer the same number of Involved to Roth’s case, but in the second scenario, it would cost $2,400 less to do so than in the first – just because stock value has fallen.

When the shares regain their previous highs, you will have already transferred them to your Roth IRA and can enjoy years of tax recovery.

Useful Roth Transformations – But Beware

Roth conversions during market downturns can make a lot of sense, especially because you’ll see huge tax benefits when the markets recover and account values ​​start rising again. However, you’ll need to keep in mind that Roth transfers cost money – and sometimes a lot of money – so be prepared to pay any associated taxes that arise after the transfer.

Nothing beats powerful tax strategies when implemented correctly. If you’re having trouble determining your total income for the year or the topic of Roth transfers still seems murky to you, be sure to visit a certified public accountant (CPA) or certified financial planner (CFP) practitioner who can walk you through the process.

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