This year’s market correction has been severe enough that it’s causing some investors to feel like they should “do something!” in response. Our advice? Stay calm and don’t take dramatic action. Instead, wait for an official triggering of SMI’s Bear Alert Indicator before making any material portfolio adjustments. If you are following SMI’s Dynamic Asset Allocation (DAA) strategy, there’s even less reason to take action. That strategy automatically guides investors completely out of stocks at times based on the recent momentum of various asset classes.
So with the exception of the protective portfolio changes we outlined for certain readers in On Bear Markets and Boundaries, we generally encourage our readers to stay the course and not make big changes to their portfolios in response to a falling market. However, there is one area where a significant change in response to a falling market can pay off for years to come. When it comes to converting a Traditional IRA to a Roth IRA, there’s no better time than during a bear market.
To review, from the time Roth IRAs were created until 2009, only those with annual incomes under $100,000 were permitted to convert a Traditional IRA to a Roth IRA. In 2010, this income ceiling restriction was finally removed, clearing the way for higher-income individuals to convert Traditional IRAs to Roths.
Tax basics of Roth vs Traditional IRAs
Making a good decision about whether to convert requires a basic understanding of how the two types of IRAs differ. One difference of particular importance to those who are already retired is that, unlike Traditional IRAs, Roths have no mandatory distribution age. This gives an account owner greater flexibility regarding when money is withdrawn and makes it easier to pass on an account to heirs. But the most significant difference has to do with the type of tax treatment each IRA receives.
- Traditional IRAs: Tax deduction now, but pay taxes later. The U.S. government allows an upfront tax deduction for taxpayers who contribute to a Traditional IRA (taxable income is reduced by the amount of the contribution). The tax bite comes later—when money is taken out of the IRA (withdrawals can begin at age 59½ and must begin by age 70½). All funds withdrawn from a Traditional IRA—i.e., both contributions and earnings—are taxed at whatever applicable income-tax rates are in effect when the withdrawals are made.
- Roth IRAs: No tax deduction now, but no taxes later. In contrast, Roth accounts work the opposite way. Account holders get no tax deduction for making contributions, but when qualified withdrawals are made in retirement, all funds—including earnings—come out tax-free. (For withdrawal of earnings to be tax-free, the account holder must meet rules related to a minimum five-year holding period.)
The difference in tax treatment means that if you convert money from a Traditional IRA (in which contributions weren’t taxed initially) to a Roth (from which withdrawals won’t be taxed later), the IRS wants its cut at the time of conversion.
For example, if your marginal federal tax rate (the top rate you currently pay) is 25% and you convert $100,000 from a Traditional IRA to a Roth, you’ll have to pay an additional $25,000 in tax. Ouch! But the upside is that future withdrawals from your Roth account will be tax-free, no matter how much your account grows in the future. (This assumes no future changes in the law regarding taxation of Roth withdrawals.) Usually, the longer you have before retirement, the more it makes sense to convert, because you have a longer time for earnings growth to make up for the tax hit.
When stock prices fall, as they have in early 2016, the value of your IRA drops and thus the tax cost of converting to a Roth IRA is reduced as well. Whatever your marginal (highest) tax rate is, it will be applied to the value of your converted holdings as of the conversion date. (It’s worth noting that most experts advise converting only if you can afford to pay the taxes from resources outside of your IRA.)
Considering the cost
Unfortunately, the Roth-conversion decision can be somewhat complicated. For example, a conversion may affect other aspects of your overall tax picture: you might be pushed temporarily into a higher tax bracket, disqualifying you from tax breaks such as the child tax credit or the college-tuition credit. Or you might be pushed into the parallel world of the Alternative Minimum Tax (AMT). Additionally, the conversion amount could bump your income up enough that you have to make quarterly tax payments (or increase withholding) to avoid an underpayment penalty on your next tax return. On the other hand, it is possible that not converting could force a widowed spouse to pay more in taxes as a single filer in the future.
Because there are so many potential variables with an IRA conversion decision, it usually makes sense to consult with a tax advisor who can run multiple “what-if” scenarios for you. But if you’re a diehard do-it-yourselfer—or if you just want to get a general idea of what you’re facing before you talk with a tax advisor—you can run some numbers using a Roth conversion calculator. Many of these are available on the web, usually sponsored by fund companies and financial planners hoping to drum up Roth-conversion business.
As you weigh the costs and benefits of a conversion, keep two things in mind: (1) a Roth conversion doesn’t have to be an all-or-nothing proposition. You can convert a Traditional IRA to a Roth one piece at a time over several years, allowing you to keep the tax on each transaction at a level you can handle; (2) even if a conversion doesn’t make financial sense in your case, that doesn’t mean you can’t have a Roth IRA. Unless your income exceeds the contribution limits, you can open a Roth account and start making contributions at any time. Single taxpayers earning $132,000 or more (modified adjusted gross income, or MAGI) and married filing-jointly taxpayers earning $194,000 or more (MAGI) are not allowed to contribute to Roth IRAs.)
When contemplating whether to convert an IRA, it’s important to consider your likely retirement income. In 2016, a married couple will pay Federal income tax of only 10% on their first $18,550 of taxable income, 15% on their next $56,750, and 25% on the next $76,600. Unless you anticipate having annual taxable income in excess of the equivalent of $151,900 (in 2016 dollars), you probably wouldn’t want to pay taxes on an IRA conversion today at a rate higher than 25%. Projecting your retirement income can be tricky, but remember, you’ll get to fill in those lower brackets with quite a bit of income each year before even reaching the 25% bracket. If you anticipate your total annual retirement income—including IRA withdrawals—being less than those rough levels, then beware converting an IRA at a higher tax rate today than you might likely eventually pay in retirement.
One more consideration: The national-debt situation has made some people question the wisdom of converting. If eventual legislative changes result in the implementation of a value-added tax (VAT) or other consumption tax (on the purchase of goods and services) while at the same time lowering marginal income-tax rates, the tax benefit of a Roth IRA would be eroded.
Clearly, many factors need to be considered, but if you weigh the evidence and decide converting to a Roth is a good idea, market declines present a particularly attractive time to do so. Working through the decision process with your tax professional now may put you in position to take swift action either now or later in the year, should the current market correction transform into a full-blown bear market.