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Converting to a Roth IRA Can Provide a Big Tax Win

With the recent decline in the stock market, some investors may have experienced a substantial loss of value. When this happens, it is important to assess the damage and make a smart move.  Some investors are already making one of these moves, which is converting their traditional retirement accounts to a Roth IRA. Transferring funds from a traditional IRA or 401(k) into a Roth IRA or 401(k) can have massive tax benefits, however, there are some things to consider before making a switch, some of which will be covered below.

How Does a Roth Conversion Work?

A Roth conversion is the voluntary conversion of a pre-tax retirement account.  Instead of continuing to utilize a traditional accounts tax deduction upon contribution, you are opting to take the Roth’s tax-free distributions. So where does the accumulated tax from the traditional account go?

When you convert to a Roth, the amount converted is added to your total income for the year and taxed at your highest marginal tax rate.  The advantage of doing this after the market has fallen is that you will pay less tax upon conversion.  In the future, when the market recovers, your money will also recover under tax-exempt Roth status.  For those looking to alleviate tax bills upon retirement, this can be a huge advantage.

Ideally, a Roth conversion should take place after two events happen; a time of depressed prices in the stock market, and during a lower-than-usual income year.  This timing will allow you to take advantage of both lower valuations, and lower tax brackets, minimizing your long-run tax burden.  While you may not now be experiencing a lower-than-average income year, the market has already fallen this year, so it still may be a great time to make the conversion.

How Much Can I Save?

Let’s lay out a working example to show you how these savings can work.  Imagine you have saved up $100,000 in a traditional IRA, with all contributions being tax-deductible.  Now let’s assume your total income falls within the 24% tax bracket when going for the conversion.  A full conversion would have you paying $24,000 in taxes.  Now let’s consider the market downturn, and say that your account balance fell to $80,000.  A full conversion on this would have you paying $19,200 in taxes, saving you almost $5,000 in taxes.

While this example may be oversimplified, it should help illustrate how you can save a lump sum of money in taxes.

Given the fluctuation in the market over the last few months, this strategy is gaining more and more traction with investors. Roth conversions have been up 18% during the first quarter of this year when compared to the same quarter last year, according to data available from Fidelity Investments.

Wrap up

With the volatility in the market recently, it can be tough to know what to do to get the most value out of your retirement accounts. There are many different stipulations and caveats about how to go about converting a retirement account, and when the best time is to do so. The best advice would be to talk to a trusted financial advisor and have them assess what decision is the best for you and your future.

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