With retirement balances down, a Roth conversion may make sense

Many investors have watched their long-term retirement savings fall nearly 20 percent this year. For perspective, if your IRA was $500,000, you may have lost nearly $100,000 since the start of the year. That hurts when you put some real numbers behind it.

With inflation increasing your everyday costs and waning consumer sentiment, it can be hard to find opportunities in the current economy. However, depressed account balances may provide an opportunity for investors to convert traditional retirement accounts to Roth IRAs. The more equity losses are, the more attractive a conversion can become.

Roth IRAs have many advantages, including tax-free growth of money, no required minimum distributions, and the ability to tap principal after five years. Converting traditional IRA funds to a Roth IRA can help you lower your required minimum distributions and use it as an estate planning tool to provide a tax-free inheritance for your heirs. Roth IRAs also allow investors to have a bucket of tax-free funds in retirement.

Unfortunately, Roth IRA contributions are only available to those with modified gross income less than $144,000 for the tax year 2022 for single filers and under $214,000 for those married filing jointly. However, all investors are allowed to convert a traditional IRA to a Roth IRA regardless of income.

Let’s say your $500,000 IRA is only down to $435,000. Ordinary income tax is due on the amount converted to a Roth, so you will pay less tax by converting a lower amount. If you are married filing jointly and in the 24 percent tax bracket, that could save you an estimated $15,600 in taxes ($500,000 x 24% = $120,000 while $435,000 x 24% = $104,400). I highly recommend being able to pay the tax due from another account like a brokerage or savings account. Paying the tax due from the converted funds would at best reduce the value of the assets receiving the tax-free growth, or at worst may constitute an early withdrawal penalty and could negate any benefit.

A Roth conversion isn’t all or nothing either. Working with your financial and tax advisers, you can determine how much to convert, keeping you from moving into a higher tax bracket for the year. You could also choose to convert only a portion now and wait to see where the market continues to move. Should the market continue to fall, you could convert more later in the year. Furthermore, you don’t have to liquidate your account to make a conversion—your investments can stay intact, so there is no risk of being out of the market. You can also pick specific funds to move from the IRA to the Roth, choosing to move shares having the deepest losses for the year—especially if they’re high-quality stocks that you expect will recover.

If you have a 401(k) at a previous employer, you can move your balance to an IRA Rollover account and then convert the money to a Roth IRA. Additionally, some 401(k) plans allow for in-plan conversions that may allow you to convert tax-deferred 401(k) funds to a Roth 401(k), gaining you similar tax-free growth. However, while there may not be early-withdrawal penalties, this is still considered a taxable event.

William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial and a co-host on Atlanta’s longest running, most respected financial talk radio show “Money Talks” airing Saturdays at 10 a.m. on AM 920 The Answer. Mr. Lako

is a CERTIFIED FINANCIAL PLANNER™ professional.