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If you're earning a high income or holding a traditional IRA, you may be considering converting to a Roth IRA to benefit from tax savings and easier access to your funds, based on your unique situation. The timing of this conversion is key, but while there is no 'perfect' time, many financial advisors recommend taking action during a market downturn.
The reason is that converting to a Roth IRA means transferring funds from a pre-tax account to a post-tax account, which triggers a taxable event. You'll owe taxes on the amount you convert now (instead of later when it's left in a traditional IRA) according to your current income tax rate. So, when the market is down, the 'cost' of converting is lower.
"If your traditional IRA was worth $100,000 in September and the market drops, leaving your investments at $80,000, you’d owe less in taxes on a Roth conversion," explains David Day, a Certified Financial Planner based in Colorado. "This makes sense because there's $20,000 less income to be taxed."
Beth Agnello, a financial planner from North Carolina, suggests visualizing it like this: Imagine you deferred taxes on $1,000 by investing it in a 401(k) or traditional IRA. If the market dips and your investment value drops to $750, and if you decide a Roth conversion is right for you (more on that later), you can convert to a Roth and benefit from these advantages, assuming you're able to pay taxes on the $750 at your current tax rate.
You’ll be taxed on $750 instead of $1,000, which means you’ll "forever avoid taxation on $250."
Additionally, once your funds are in a Roth, you’ll never face taxes on them again (as long as you adhere to the withdrawal guidelines). As Agnello puts it, "When the market rebounds, and your equity appreciates in value, you won’t owe any taxes when you withdraw from your Roth."
When is the Right Time to Convert to a Roth?
There are several other considerations to weigh before making the decision.
"Be cautious about converting too much at once, as it can push you into a higher tax bracket," advises Day, since the converted amount is treated as taxable income. A good strategy may be to spread the conversion over multiple years, especially if you are close to a higher tax threshold.
According to Andrew Marshall, a financial planner from San Diego, while a market dip can be beneficial, it shouldn't be the primary factor in deciding to convert. "Conversions are best done in years with lower income," Marshall explains. "This is typically the case in the early years of retirement, but may also happen if you experience unemployment or reduced work hours. If these circumstances align with a market dip, it could be a great time to convert to a Roth IRA."
Gordan Achtermann, a Certified Financial Planner from Virginia, emphasizes the key question: "Can you afford the taxes due on the conversion?"
"A core assumption of the traditional IRA is that your tax rate will be lower in retirement than while you're working," explains Achtermann. "If you anticipate your tax rate will stay the same or rise after retirement, then opting for a Roth is likely the better choice, as it allows for tax-free growth as long as the account is maintained."
Once you've determined that a Roth is the optimal option, the timing of the conversion becomes important. "The earlier the conversion, the more time it has to grow tax-free, but timing isn't the only factor to consider," he advises.
Glenda Moehlenpah, a California-based CFP, highlights that what you convert is just as important as when. You’re only truly gaining an advantage if the asset you're converting has decreased in value (for instance, converting cash may not offer any extra benefits).
"This is more of a psychological 'win,' as you're capitalizing on the market's dip," she says.
Keep in mind: This isn't a decision to make just because the market had a one-day dip. It requires careful planning.
"Timing the market is tough, which makes pinpointing the market's lowest point for optimal tax savings equally challenging," says Steve Martin, a wealth advisor based in Florida. He adds, "The Roth conversion strategy is meant for the long haul, so long-term factors usually carry more weight than short-term market fluctuations."
