Making regular contributions to tax-advantaged retirement accounts is one of the most effective ways to build financial security over the long run. Given the current state of global stock markets, it’s natural to rethink how you can get the most out of your 401(k)s and IRAs once you’ve built up healthy balances. A popular strategy is the Roth conversion.
Here, we’ll briefly review what a Roth conversion is, how one would play out in reality, and if now is the right time to move ahead with one.
How a Roth conversion works
Most people fund their retirement through traditional 401(k)s or IRAs, which usually provide a tax deduction at the time of contribution. These accounts function as tax-deferred accounts; in other words, you trade paying tax today for the obligation to pay at some point in the future (when money is withdrawn or converted.) Along the way, you receive tax-deferred growth, which can help accelerate the effects of compound interest.
A Roth conversion is the voluntary conversion of all or a portion of a pre-tax retirement account. Instead of opting for more tax deferral, you choose to declare a portion of your pre-tax investments as income today, ideally to save on taxes in the long run. If you’re still working, you may only be able to do this with your traditional IRA balances, although some companies offer “in-plan” Roth conversions as part of their 401(k) offerings.
When you perform a Roth conversion, the amount converted is added to your total income for the year and taxed at your highest marginal tax rate. The advantage to doing this after the market has fallen is that you’ll pay less tax upon conversion; when the market recovers in the future, your money will recover under tax-exempt Roth status. This can be a tremendous advantage to those concerned about exorbitant tax bills in retirement.
Is now the right time for a Roth conversion?
The ideal time to initiate a Roth conversion is at the intersection of two events: a lower-than-usual income year and a time of depressed prices in the stock market. Converting at a time like that allows you to take advantage of lower tax brackets and lower valuations to minimize your long-run tax burden.
