So far this year, we’ve seen quite a bit of market volatility. That’s normal, of course - and certainly over the past two years, investors have experienced a few significant swings in the stock market. While we know that volatility is just part of investing, it’s completely understandable for investors to feel a little uncomfortable when volatility takes hold. We’ll always recommend thinking about those moments in a proactive, and not a reactive way; letting your emotions guide your investment strategy in the moment may not work well in the long-term (or even the short-term). So, what strategy can investors consider when the markets are down from a tax standpoint? One option that may fit your needs is a Roth IRA conversion.
Roth IRA Conversion in Action
Let’s say an investor wants to convert $100k from an IRA to a Roth IRA. Doing so means that the investor will be claiming that $100k on their tax return as ordinary income.
For the purposes of this example, we’re going to assume that the investor is over the age of 59 ½ so that there is no withdrawal penalty fee. The IRA in this example yields a 7% rate of return annually. The investor is in the 22% federal tax bracket with an 8% state tax rate, which would mean a 30% marginal tax bracket.
Using these numbers, we can calculate the following: We start with $100k, but we need to take taxes out. In our example, the tax due is $30,000 ($100,000 x .30). That leaves us with $70,000 to convert. If we factor in the 7% rate of return on that $70,000, over a 10-year period, the Roth IRA would be worth about $137,700. And, as long as the investment stays in the Roth IRA for 5 years or more, the money will grow tax free.
Roth IRA Conversion in a Down Market
To see the benefits of a Roth IRA conversion when the markets are down, we’re going to use the above example. But in this instance, the stock price is down by 30%. Instead of $100k, the investor will be converting $70,000. Multiplying that amount by .30 (the 30% tax rate) results in $21,000 taxes due, with a final conversion amount of $49,000.
The tax burden on the ordinary income is less because the stock price was down initially. However, the recovery of the stock price and growth that takes place in the future will be tax-free after the 5th year following conversion to Roth IRA. The compounding effect can be hugely beneficial.
Is a Roth IRA Conversion Right for You?
A Roth IRA conversion may not be the right strategy for everyone, especially if you’re seeking a solution for the short term. But if you’re a long-term investor who has been thinking about converting, now might be a good time. With the current market conditions, and in instances where the market is down, it’s worth discussing with your tax professional and financial advisor about whether a Roth IRA conversion can be a good option for you. If you would like to discuss this strategy, please contact us.
The Team at Chatterton & Associates
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc nor its representatives provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.