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Should I Convert My Traditional IRA to a Roth IRA When the Market Is Down?

If you’ve been thinking about converting money from a traditional individual retirement account (IRA) to a Roth IRA, this may be a prime time to bust a move.

Last Monday, the Dow Jones Industrial Average plunged 876 points following a stomach-churning inflation report. The S&P 500 stepped into bear-market territory after dropping 3.9%, or 151.23 points. On top of that, the Federal Reserve raised interest rates by 75 basis points during June’s Federal Open Market Committee meeting.

The recent market moves may not be good for your portfolio, but it could be a potential win if you decide to do a Roth conversion. Here are a few items to consider before you shift funds from a traditional to a Roth IRA. 

Image source: Getty Images.

How traditional and Roth IRAs work 

IRAs, both the traditional and Roth versions, can boost retirement savings while helping you rack up on tax benefits.

The timing of your tax perks is based on the account you choose to put your money in. A traditional IRA allows you to set aside pretax funds for retirement. You won’t have to pay taxes on the money until you withdraw the money, usually years later in retirement, often when your tax rate has dropped. 

On the flip side, you pay taxes on your Roth IRA dollars immediately. You can take care of your tax bill up front and enjoy tax-free growth and withdrawals during retirement. But you must not exceed income limits to qualify for making direct contributions to a Roth IRA. High earners can sidestep that limitation through a Roth IRA conversion

Trading in a traditional 401(k) for a Roth IRA

If you have money sitting in a traditional IRA right now, it doesn’t have to stay there until retirement. You can transfer the money to a Roth IRA and position yourself for tax-free income later. 

That may sound simple, but there’s one thing that could stand in your way: taxes. Because you may not have paid taxes on your contributions to the traditional IRA, you’ll have to do it in the year you make the Roth conversion. The amount you transfer between accounts will be taxed at ordinary income rates. If you’re moving over a substantial balance, that extra money can even push your income into another bracket. 

A Roth conversion may be better now than later 

Let’s say you had $100,000 in a traditional IRA, but the value fell to $70,000 when the market dropped. You can save money by converting $70,000 to the Roth IRA rather than the original $100,000. If the stocks in your portfolio recover, you’ll be able to enjoy those gains in your Roth account without worrying about taxes when you withdraw the money. 

Although you may get away with paying less taxes during a market downturn, that doesn’t mean you should automatically commit to a Roth conversion right now. You should speak to your tax professional or accountant to make sure you are headed down the right path.

Here are some questions to consider before moving forward with a Roth conversion: 

Do you expect to make more money in 2022, pushing you into a higher tax bracket? 
How much money do you want to transfer from a traditional to a Roth IRA?
Did you make nondeductible contributions to a traditional IRA?
What tax bracket would you fall in after doing a Roth conversion?
Are you familiar with the five-year rule for Roth conversions? 
How much will you have to pay in taxes?

If you’re not prepared for the taxes, it may not make sense to do a Roth conversion now. But tax rates are expected to go up later, so you need to choose your battle. Take a look at the ordinary income tax rates below for 2022 so you can know what to expect.

Single

Married Filing Jointly

Head of Household

Rate

$0 to $10,275

$0 to $20,550

Up to $14,650

10%

$10,276 to $41,775

$20,551 to $83,550

$14,651 to $55,900

12%

$41,776 to $89,075

$83,551 to $178,150

$55,901 to $89,050

22%

$89,076 to $170,050

$178,151 to $340,100

$89,051 to $170,050

24%

$170,051 to $215,950

$340,101 to $431,900

$170,051 to $215,950

32%

$215,951 to $539,900

$431,901 to $647,850

$215,951 to $539,900

35%

Over $539,900

Over $647,850

Over $539,900

37%

Data source: IRS. 

Turn your market pain into Roth IRA gains

Your portfolio might be down right now, but that doesn’t mean you can’t unravel some unique opportunities. This may be an ideal time to do a Roth conversion if your portfolio has taken a hit. Evaluate the pros and cons so you can maximize your chances of winning big on your tax return now and securing tax-free income later. 

The Motley Fool has a disclosure policy.

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