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Making Lemonade Out of Lemons: Roth IRA Conversions

A market downturn may create a favorable tax situation for converting a traditional IRA to a Roth IRA. First of all, we’re not investment advisors, and we’re careful to not give investment advice. But, we are always on the lookout for tax advantage opportunities for clients.

If the value of a traditional IRA declines significantly, converting to a Roth IRA allows the account holder to pay taxes on the current value of the account. Then, as the market swings back up again, the owner of the account gains value without tax liability upon withdrawal.

Details of a Roth IRA Conversion

  • The person converting the account from traditional to Roth pays ordinary income taxes on the entire value of the converting amount.
  • After conversion, if there is a market rebound, the growth in the Roth account assets are tax-free.
  • If the market continues to decline after conversion and the value of the assets decrease, then transaction can be reversed up to October 15th of the year following the conversion. This is called ‘recharacterization.’
  • It’s possible to recharacterize a portion of the Roth IRA, but the amount must be a direct transfer back to the traditional IRA. The account owner cannot take a distribution and then open a new account.
  • Recharacterizing has an effect on the person’s tax return. An amended return is necessary to reverse the tax liability, and this must also happen by October 15th.
  • Account holders may then wish to convert the traditional account yet again to a Roth IRA, with a new, lower value.

Consider current and future tax brackets

Tax planners often recommend Roth conversions if clients expect to be in a higher tax bracket when it’s time to withdraw the funds. However, even at current tax rates, the trend is for taxes to rise each year. So, a Roth conversion is a relatively safe choice if a person has funds available to pay the taxes now.

Roth IRAs don’t carry a required minimum distribution (RMD) amount like traditional IRAs. For older workers, the lack of RMD is a benefit, because the account owner can let the value of the account grow without having to take a withdrawal and pay tax on it.

Talk with a Salmon Sims Thomas tax advisor to determine if a Roth conversion makes sense for your financial situation.