As the impact of the COVID-19 pandemic sends shudders of uncertainty into our markets and economy, you may be feeling a lack of control over your investments. But while your retirement accounts have suffered recent losses, stock market corrections can provide financial planning opportunities that help enhance wealth when markets recover. One such opportunity to consider is converting a traditional individual retirement account (IRA) into a Roth IRA. 

Traditional vs. Roth: What’s the Difference?

Your traditional IRA enjoys a tax-advantaged status, meaning your contributions are generally deductible as you make them. When you begin withdrawing from your IRA in retirement, those distributions will be taxed as ordinary income.

A Roth IRA is a bit like the reverse of a traditional IRA. You don’t receive the upfront tax deduction of the traditional IRA, but any growth in your portfolio plus your distributions will be tax-free. These tax-free withdrawals can play a critical role in your income and tax strategy in retirement.

Why Convert to a Roth IRA?

When you convert your traditional IRA, you are taking the balance of the account and moving it into a Roth IRA. As part of the process, you will have to pay income taxes on the money that you convert, so it’s important to consider the trade-off between the taxes paid now and the potential taxes in retirement.

If you’re unsure about that trade-off, talking with a financial advisor could help give you clarity. For example, our financial advisory firm considers whether a Roth conversion would benefit a client based on the entirety of their financial situation as well as their goals for retirement. 

If your portfolio balance has dropped, then you may find it even more beneficial to convert a traditional IRA into a Roth since you will pay less in taxes now than you would have even a few weeks ago.

How an IRA Conversion Works

Rolling over an IRA requires you to adhere to the rules set forth by the IRS. Perhaps the easiest way to avoid mistakes—and penalties—is to have your IRA account trustee transfer the funds on your behalf.

If they don’t do this but instead send you a check for the distribution, you must roll that money into a Roth account within 60 days. If you don’t, you could be subject to a 10% penalty on top of taxes. 

After you convert the funds, you simply have to wait. The IRS requires you to wait five years before you can withdraw money from your Roth IRA tax-free and without penalty.

How This Investment Strategy Can Help

This strategy can be particularly helpful if your income is too high to directly contribute to a Roth IRA, as anyone can make a Roth IRA conversion. Once the conversion is complete, you can enjoy the benefits that come with a Roth IRA. In addition to tax-free withdrawals, you do not have to take required minimum distributions (RMDs), so you can continue to grow this account tax-free.

Another reason why you may want to roll over your traditional IRA into a Roth IRA is that income tax rates are historically low, especially with the temporary cut in rates due to the Tax Cuts and Jobs Act of 2017. Income taxes could increase by the time you retire, so being proactive now could help you reduce your taxable income in retirement while helping offset the current stock market decline. 

Risks of Converting a Traditional IRA to a Roth IRA

While Roth conversions can give you income and tax flexibility in retirement, you need to consider how converting the IRA balance will affect your current gross income. Rolling over a significant balance could put you into a higher income tax bracket and leave you with a bigger tax bill.

However, if you expect to have a reduced income this year because of the coronavirus fallout, then it is even more reason to consider taking advantage of your lower tax bracket and completing a Roth IRA conversion. 

Rolling over your IRA balance also poses the risk that you end up paying more taxes in the long run if tax rates fall below than where they are now.

Talking with a fiduciary financial advisor could help you determine whether a Roth conversion is a good strategy for you to take advantage of in this market downturn. Ideally, your advisor will help you make this determination as part of your overall financial plan and objectives.

Navigating stock market declines can be challenging, but using strategies like converting a traditional IRA to a Roth IRA can help you feel like you are in more control and making the most of a difficult situation.

This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.