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This IRA move looks smarter after the stock market correction

One of the biggest problems with the way that most people save for retirement is that they fail to take taxes fully into consideration. With traditional IRAs and 401(k) plans, you typically set aside pre-tax money into a tax-deferred account that shelters your money from tax as long as it stays in the account. But once you start taking withdrawals in retirement, that's when the tax bill hits, and if you're not prepared for a substantial portion of your withdrawals to end up paying Uncle Sam, the tax implications can come as a major shock.

To follow is to use Roth IRAs for all or part of your retirement saving. These retirement accounts don't give you an upfront tax break, but they do let you take withdrawals during retirement on a tax-free basis. Moreover, if you started with a traditional IRA but want to switch to a Roth, you can by doing what's called a Roth conversion. Although some investors gave up on Roth conversions after tax reform changed one of their most beneficial aspects, it still makes sense under certain conditions to convert a traditional IRA or 401(k) to a Roth -- especially after big downturns like the one we've seen recently.

How Roth conversions work

If you have money in a traditional IRA, then you can convert all or a portion of your account to a Roth IRA whenever you want. Thereafter, the money in the newly formed Roth IRA will have the same beneficial tax provisions as any other Roth, and any further growth in the assets in the Roth IRA typically won't get taxed when you make withdrawals in retirement.

However, there's a catch when you convert existing traditional IRAs to Roth IRAs. You have to include the value of the assets you convert as taxable income for the tax year in which you make the conversion. Effectively, the decision you have to make is whether it makes sense to pay taxes now at whatever rate of tax applies in your current financial situation, or wait until later to pay taxes when you withdraw money in retirement. A big part of that question depends on how much you expect your money to grow after making the conversion.

Until a couple years ago, you used to have an opportunity to get what amounted to a free look at a crystal ball. Old tax laws would let you undo your Roth conversion at any time before the extended due date for your tax return for the tax year in which you made the conversion. That gave taxpayers up to 21 months to see what would happen to their converted account. If the value went up, then they could leave the conversion in place. If it went down, though, they could undo the conversion with no tax consequences at all. It was a winning strategy all the way around.

Unfortunately, lawmakers removed the ability to recharacterize Roth conversions in the tax reform package in late 2017. Now, once you do a conversion, you're stuck with it -- even if the value of the converted assets keeps going down.

When Roth conversions still make sense

Even without the ability to undo them, Roth conversions can still be a great way to tap into tax-free growth. In particular, if you expect that the current low income tax rates aren't likely to last, then doing a Roth conversion effectively locks in those tax rates in exchange for paying no taxes during your retirement.

The reason why it's important to look at Roth conversions right now is that with the stock market having entered a correction, the value of your IRA assets is probably down from where your account started the year. That means you can convert your IRA to a Roth with less of a tax hit, and if the stocks bounce back after you convert, then the resulting gains will be tax-free.

Falling markets can be tough to endure, but they do open the door to some retirement planning. By looking at the possibility of a Roth conversion, you can take advantage of low stock prices and buy yourself a future tax break more cheaply.

 

This article was written by Dan Caplinger from The Motley Fool and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

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