Do you have money in a Traditional IRA? Do you know that when you withdraw money from your Traditional IRA it will be taxed (excluding any after-tax, NON-deductible contributions)? It's not a matter of if this money will be taxed, but when. Same thing with your Simple IRA, SEP IRA, and also any pre-tax money you have in your work retirement plan (401k, 403b, etc).
What can you do to potentially save on taxes? Consider doing an IRA conversion when the assets in your Traditional IRA are depressed in value...like, during a stock market correction. A stock market correction might provide a great opportunity to convert your pre-tax IRA money into your tax-free Roth IRA.
What is an IRA conversion? With an IRA conversion, you are simply moving (converting) money from your Traditional IRA into your Roth IRA. When you move (convert) pre-tax money from your Traditional IRA to your Roth IRA, you will owe taxes on the amount you move (convert) into your Roth IRA...but then this money can grow tax free.
When is a good time to do an IRA conversion? Consider doing an IRA conversion when the stock market, and likely your account, experiences a correction (say 10-20%+). This way, you are paying taxes on a depressed value. And any recovery of the assets you convert will then be tax free…because now the money is in your tax-free Roth IRA.
Here's a hypothetical example: Let's say you have $250,000 in a Traditional IRA, and your account experiences a 20% correction and is now worth $200,000. Because the account is at a depressed level, you decide to convert this $200,000 from your Traditional IRA into your Roth IRA and pay the taxes on this $200,000. As long as you leave this money in your Roth IRA until you are 59 1/2, you will never owe taxes on this money again, including any future growth. So, if/when your account recovers back to its previous level of $250,000, you will avoid paying future taxes on the $50,000 recovery...plus any potential growth beyond $250,000. And there, you just took advantage of a stock market correction, potentially saving you on future taxes.
When do you have to pay the taxes on an IRA conversion? The amount you move (convert) from your Traditional IRA into your Roth IRA will be added to your taxable income in the calendar year that you do the conversion. So make sure you have enough money available in a non-IRA account (checking, savings, taxable brokerage account, etc) to pay the taxes on any amount you move (convert) from your Traditional IRA to your Roth IRA.
Can you have the taxes withheld from your IRA conversion? If you are under the age of 59 ½, do NOT have the taxes withheld from your IRA conversion as any amount withheld will be considered an early distribution and subject to an additional 10% penalty tax. If you are over the age of 59 ½, this 10% penalty tax doesn’t apply. So in this case, you could have the taxes withheld from your IRA conversion, but I suggest paying the IRA conversion taxes with other money (checking, savings, taxable brokerage account, etc) as this would allow you to keep the maximum amount in your tax-free Roth IRA.
Do you have to move (convert) ALL the money from your Traditional IRA into your Roth IRA? Nope. This isn’t an all or none thing. You can convert as much or as little as you choose...you don't have to convert your entire IRA all in one year. You can do a "partial" IRA conversion. Why is this important? Because if an IRA conversion would bump you up into the next tax bracket (remember, the amount you convert is added to your taxable income), then you might consider doing a "partial" IRA conversion.
When is another good time to consider an IRA conversion? Another good time to consider an IRA conversion is when you are having a down income year AND you think you will be in a lower tax bracket. Maybe it's a year when you have a large tax write off (business expenses, etc). You are going to pay taxes on these IRA assets someday anyway, so if you can pay in a year when your tax rate is lower, that’s a good thing. Again, just make sure you have enough available cash to pay the taxes on your IRA conversion.
Other benefits of doing an IRA conversion: Remember the ‘Backdoor Roth IRA Strategy’? If you move/convert all your pre-tax money into your Roth IRA, it makes this strategy more doable. Also, unlike money in a Traditional IRA, money in a Roth IRA is NOT subject to Required Minimum Distributions (RMDs) when you reach age 70 1/2. And finally, by paying taxes on converted IRA money now versus later, you eliminate the unknown risk of what tax brackets might look like in the future.
Want to run the numbers yourself? Bankrate has a very helpful calculator that allows you to do your own IRA conversion analysis. Here is the link: Convert IRA to Roth IRA Calculator (Click here)
What should you do? Before you do anything, run this by your tax advisor. I do NOT recommend doing an IRA conversion without discussing it with your tax advisor. If you have money in an IRA account (Traditional IRA, SEP IRA, Simple IRA, etc) or old work retirement plan (401k, etc), share this article with them (copy, paste and email the link). Ask them if you would benefit from converting some or all of your IRA/401k money into a tax-free Roth IRA.
HyLine Bottom Line: An IRA conversion is one way to take advantage of a stock market correction. By doing an IRA conversion, you might be able to save yourself a lot of money on future taxes.
Questions? Don’t hesitate to reach out. If you have questions on anything, feel free to email me at firstname.lastname@example.org or call me at (605) 275-2343.
Think some of your friends might benefit from doing an IRA conversion? Great! Use the social media links at the bottom of the page to share this with them.
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HyLine Wealth is an investment advisor firm registered in the State of South Dakota. We do not provide tax or legal advice. Past performance is no guarantee of future results. Always consult your financial advisor, tax advisor, attorney, and/or insurance agent before implementing any specific strategy to make sure it is right for you and your unique situation. We are not responsible for the accuracy or upkeep of information on the links we provide to outside websites. If/when we provide a link to an outside website, be sure to independently confirm the accuracy of any information.