If you're a stock market investor, 2022 has been, well, less than ideal. The broad stock market entered bear territory earlier this summer, and even with a recent uptick, the S&P 500 has still surrendered more than 16% so far this year.
But a decline in the value of your portfolio may actually be advantageous for certain investors who hold funds in traditional, pre-tax IRAs: The lower the value of your portfolio, the cheaper it will be to convert your funds into a Roth IRA.
The move is potentially lucrative for younger people, who stand to benefit most from switching to an account where their assets can grow and generally be withdrawn tax-free in retirement.
In fact, if you're early in your career, a so-called "Roth conversion" is smart, regardless of what the market is doing, says Ed Slott, a certified financial planner and founder of IRAHelp.com.
For younger people, "it's a perfect time to convert, whether things are up or down. It's a long-term move," he says. The price of stocks at this very moment tends not to matter much for a move whose results will take decades to shake out.
"Of course, if the market is down, you can convert more," Slott adds.
If you have a traditional IRA, here's why financial pros say it's worth considering a Roth conversion.
First, it's important to understand what makes traditional and Roth IRAs different.
Traditional IRAs are funded with money you've yet to pay taxes on. That means you can typically deduct your contributions to these accounts from your taxable income each year. In exchange for this upfront tax break, you'll owe tax on any money that you withdraw in retirement. Take money out before age 59½, and you'll owe a 10% penalty in addition to your tax bill.
Roth IRAs, on the other hand, are funded with money you've already paid tax on, meaning your contributions don't count against your taxable income. But once you turn 59½, provided you've held the account for five years, you can withdraw all of your money, including any investment gains that have accumulated, tax-free. Plus, you can withdraw up to the amount that you've contributed any time without owing tax.
The advantage of using one account over another depends on the individual, but the younger you are, the more a Roth makes sense, says Slott. "Young people should only be doing Roths," he says. "Why start building a taxable account when you have the option to build a tax-free one?"
For those who agree with Slott, the calculus comes down to whether you think you'll owe more taxes now or later. Because younger people tend to be in lower tax brackets, the thinking goes, they stand to gain from paying lower taxes up front and avoiding higher taxes they may owe at the end of their career.
Even if you're unsure what tax bracket you'll belong to by the time you retire, this strategy protects against the possibility that tax rates could go up across the board in the future.
Say you have a traditional IRA and you want to convert it to a Roth. Once you make the conversion, remember: since you didn't pay tax up front, you will owe income tax on the amount of money you convert to a Roth.
This is where a portfolio that has declined in value can come in handy, says Bill Van Sant, a certified financial planner and managing director at wealth advisory firm Girard.
"For a conversion, you're taxed on the dollar amount that's converted, which will be lower when your account is down," he says. "You may own 100 shares. If your account is down 20%, you can still convert those 100 shares, but the tax due will be down 20%."
Consider the following example from Ashton Lawrence, a CFP at Goldfinch Wealth Management in Greenville, South Carolina, which uses nice round numbers to illustrate the point. If you convert a $100,000 Roth account and owe 20% in federal taxes, you'd incur a tax bill of $20,000. If those same assets declined 35% to $65,000, converting those same shares would run you $13,000.
"And should those assets recover, all of that growth could then lead to tax-free distributions" when you retire, he says.
As with any investing move, avoid converting a traditional IRA to a Roth solely because of the potential tax savings of doing it when the market is down. "This is a long-term investment and is much more about your tax bracket now versus later than what the market is doing," says Slott.
If you're young and don't have much money, a conversion could be a relatively straightforward move. But those with more assets and more complicated financial situations would be wise to consult a financial planner or tax pro before making a move with a big chunk of cash.
Here three caveats for you and your advisor to consider.
1.The tax bill
When you make a conversion, you'd be wise to pay the upfront tax bill using money from an outside stash of cash, says Van Sant. "That money shouldn't be coming out of the account you're converting, because then you're not getting the full effect of the conversion," he says. "It's going to take you longer to recoup that money."
If you don't have enough cash lying around to cover the bill, you can convert a little bit at a time, on a monthly or annual basis, suggests Slott. "You don't want to go broke converting," he says.
2. The five-year rule
Remember that Roth perk where you can withdraw your contributions at any time? Sorry, that doesn't apply for owners of converted Roth IRAs, who must wait five years before they can withdraw any funds from the account without incurring a 10% penalty.
Ideally, if you're young, this rule won't come into play because you won't touch the money until it's time to withdraw it in retirement. However, if you suspect you might need some of your money in the next five years, a conversion may not be for you.
3. Your taxable income
Converting your traditional account into a Roth means boosting your overall taxable income for the year you do the conversion. That could mean pushing you into a higher tax bracket, making it more expensive for you to receive certain federal benefits or disqualifying you from receiving certain tax breaks.