When the Coronavirus sent stocks plummeting in March, it was the perfect time for many investors to convert from a traditional retirement account into a Roth IRA account. Experts say those who did not act than missed their chance because they could have converted and saved on taxes.
Roth IRAs differ from traditional IRA and 401Ks retirement accounts in how they are taxed. A traditional 401(k) or IRA allows investors to make tax-free contributions and defer taxes until the money is withdrawn. Roth IRAs are the opposite: investors pay income tax on the money when it flows in, and no income tax on it when that money comes out.
One of the other benefits of Roth IRAs is that contributions can be withdrawn early and without penalty, and are tax-free for up to five years after that.
Fidelity’s US portfolio saw a 76% increase in Roth IRA conversions in the first quarter of 2019. Momentum appeared to have continued in the second quarter, with Fidelity reporting a 1.5% increase in revenue compared with the first four months of last year.
Two factors influence how much you owe: your account balance and your income tax bracket. If you convert from a traditional IRA to a Roth, you pay income tax on the amount you converted, not on the total amount in the account.
Stocks were down in January and February before recovering from their March lows, but a new coronavirus rocked the market and also sent unemployment soaring. Since the beginning of the pandemic, a staggering 42.6 million Americans have lost their jobs, and up to 2.5 million of them may have died during the pandemic.
If you run the risk of losing your job and slipping into a lower income tax bracket, converting to a Roth IRA is an excellent opportunity because the tax burden of converting will be lower.
The coronavirus pandemic has also forced over 100k businesses to close according to Newsweek.
For entrepreneurs with taxable losses, a Roth conversion could be a way to cover some of those costs. Tax losses can be used to offset other income, such as wages, in a personal tax return. For example, if a company generates a loss, the owner can use the loss that the company generates for an IRA conversion to generate additional revenue. The owner has a loss of $50,000 on his personal income tax return. Still, the losses from the conversion offset the others, leaving the owners a taxable income of $100,500 and an additional IRA income of $10,200 in Roth.
You would effectively only pay taxes on the wages you have. A word of caution, the conditions for a Roth conversion are favorable does not mean that it is the right step for everyone.
If you are new to the labor market as a young person and believe that you can make more money without being pushed into a higher tax bracket, then switching could be a smart move. If you are in the prime of your career, you could benefit more from the current tax-deductibility of traditional accounts.
Ultimately, withholding money from a conversion without paying taxes diminishes the benefits of the conversion itself and could lead to unnecessary penalties. If you are younger than 59 1 / 2, you could owe an additional 10% in taxes on the amount.
It’s essential to consider whether you convert or not before you convert as well as about the impact of the conversion on the tax bill.
No one has a crystal ball showing where the stock will go from here, or when a conversion makes more sense in terms of timing.
Retirees need also to be aware that their Roth conversion income would push them into a higher Medicare income bracket, meaning they would have to pay more tax than they don’t.
The good news is that if you convert your Roth IRA in full, you can leave no money in the taxable account, and your heirs will get it free of taxes. If you convert the entire IRA and switch to a portion that doesn’t push you into the higher tax brackets, you don’t have to make a minimum distribution until age 72.
Your decision will depend on your specific situation and your goals for your money, but if you want to convert in March and haven’t done so, you have an excellent opportunity.
Tom, aka T Rex, is seasoned financial pro that cut his teeth on the Chicago trading oil futures in 1995. He has bachelor’s degree in finance and management. In less than 3 years he bought his own seat and set up shop on the exchange. For the next 10 years Rex traded his own account and some institutional accounts. In 2017, he decided to move to Florida and focus on educating traders and writing for financial websites.