Why Now May Be a Good Time to Consider a Roth Conversion

Over the course of the year, the S&P 500 declined more than 20 percent. While it’s been a difficult year for investors, declines like this are a normal part of the market’s cycle. And savvy investors know that when the market declines, opportunities abound.

One such opportunity is a Roth conversion. Depending on your situation, now may be a smart time to consider such a move.

What Is a Roth conversion?

The government offers a number of tax-advantaged ways to save for retirement. Typically, these options fall into two categories: traditional and Roth. With traditional retirement accounts (either 401(k)s or IRAs), the money you contribute is typically not taxed today, and you won’t owe tax as it grows. But in retirement, you’ll owe taxes on any distributions you take from your account. With Roth accounts, you contribute money that has already been taxed today. It then grows tax-free, and you can generally take it out in retirement without owing any tax.

A Roth conversion is simply the process of converting traditional retirement funds to Roth funds. When you do a Roth conversion, you’ll owe tax on the amount you convert in the year you convert it. But then the money will continue to grow and, in most cases, you’ll never owe tax on it again.

Should I have a Roth or traditional retirement account?

Everyone’s situation is different, but when you get to retirement, you’ll probably be in the best position if you have a mix of taxable and non-taxable income sources. Just like you diversify investments, diversifying from a tax perspective will give you flexibility to manage your taxes in retirement. Ultimately, this can help you be more efficient with your savings, meaning you send less to Uncle Sam and more to the grandkids.

Why now is a good time to consider a Roth conversion

There are many times when it might make sense to consider a Roth conversion. One key opportunity is a market decline. That’s because you’ve likely lost value in your retirement account. Here’s a brief simplified example.

Say you had $50,000 in an old traditional retirement account at the start of the year. If you’re in the 24 percent tax bracket, converting would have resulted in a $12,000 tax bill. Remember, if you do nothing, you’ll owe tax on whatever that amount grows to in retirement.

But with the market decline, let’s say your account is now worth $40,000. Converting the whole amount to a Roth now only costs $9,600 in tax. And, as your money grows over time, you’ll never owe more tax on these funds.

A few things to consider if you want to move ahead with a Roth conversion

While there are several advantages of doing a Roth conversion during a market decline, there are some things you should be aware of.

The amount of your conversion will count as taxable earnings. This means that if you earned $150,000 and you convert $40,000, your income for tax purposes will be $190,000. Depending on your situation, this could push you into a higher tax bracket.

You should be able to cover the tax with funds from outside your retirement account. Because you might face a penalty for distributing funds from a traditional account before you reach the age of 59½, you’ll want to have other funds to cover the tax bill rather than paying with funds that are already in your retirement account.

Is now the right time for a Roth conversion?

Ultimately everyone’s situation is different. A financial advisor can help you look at your financial situation broadly so that you can see how decisions like this would impact your situation.

This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.