If you’re like many people, a big chunk of your savings is tucked safely away in an IRA or 401(K). The unfortunate aspect of these plans is that you’re going to owe Uncle Sam a big chunk of those savings once you start pulling from them in retirement. Worse yet, there’s a good chance you’ll be in an even higher tax bracket than you’re currently in due to social security payments or other retirement income streams.
The Roth Conversion
Here comes the good part – there’s an IRS provision that allows you to fund a post-tax retirement plan that grows tax-free. Additionally, you can convert a portion of your current retirement plan into this provision by paying tax on it now and then letting it grow unencumbered to and through retirement. It’s called the Roth provision, a powerful retirement tool that was only introduced in 1997 by Senator Roth but whose full potential wasn’t realized until some years later.
Now, here comes the tricky part – should one convert some or all of their savings into a Roth? If the markets are down, the chances of it being worth it go way up. Let’s look at some theoretical case studies.
Case Study 1
William has faithfully contributed to his retirement plan and has accumulated 100K in his retirement account with a current $100,000 salary. He’s 40 years old, so he has at least 20 years before retiring. The market sinks and he notices a 30%(!) loss in his portfolio. William visits his Sarasota Financial Advisor to find out what he should do. His advisor reveals that if he converts that 70k now, he will be paying lower taxes overall. Because isn’t it better to pay taxes on $70,000 than on $70,000 plus 20 years of compound gains?
William decides to convert and dutifully pays taxes after a standard deduction of $12,995 leaving him with $56,320 in his sparkling new Roth 401(K). Unfortunately, William got bumped up a tax bracket during the conversion, but the savings made while converting during a downturn ended up being well worth it, as illustrated below.
In 20 years at a 6% quarterly compound interest rate (which is a conservative estimate), that $56,320 will grow into a tax-free $185,330. That’s assuming he never puts another dollar into that Roth account too. If he waits another 10 years, it will turn into $336,192. Now let’s imagine that he keeps putting in $1,708.33 every month to max out his Roth 401(K) each year – this is where the real magic happens. In 20 years, that $56,320 will transform into $967,820, and in 30 years a cool $2,033,712.
Let’s compare that with the $70,000 if William hadn’t heeded his advisor’s advice. In 20 years, he would end up with $1,012,836. If he takes his retirement out as a lump sum, he will receive only $679,924. In this case, it was well worth it to pay his taxes when he was younger (and in a lower tax bracket!).
Case Study 2
At 62 years old, Frank is nearing retirement. Over the years, he’s diligently saved $500,000 in his tax-deferred retirement plan. Suddenly, right before he was going to retire, the markets crash, wiping out 30% of his portfolio. But Frank sees an opportunity, the same one that William saw – to convert to Roth during a market downturn. He takes a big tax hit, paying taxes on $350,000. The tax bill is $107,259.5, leaving him with $230,066.53 in a post-tax Roth, allowing it to grow tax-free.
Let’s look at the numbers:
In three years, at the age he wanted to retire, he still is maxing out his Roth 401k yet his account is only worth $341,894.98 and he’s already 65 years old. He better wait a couple more years. Even if he wanted to retire, he’d be stuck taking out only contributions, because all earnings are locked in for 5 years after a Roth conversion or they’ll be hit with income taxes.
In 5 years, he’ll have only $428,351.93. Had he kept his retirement savings in his traditional IRA, in 5 years he would have had $589,885 after taxes. It was definitely not worth converting to Roth during a market downturn! Making it worse, he had to keep working that whole time, putting money into his 401(K) to make up for it. He lost precious time that could have been spent with friends and loved ones, or on hobbies, or just plain enjoying life.
In reality, a professional financial advisor would significantly reduce the chances of one finding themselves in such a bind due to careful portfolio management, but these fictional cases allow us to illustrate the difference a Roth conversion can make as part of a tax optimization strategy during a bear market.
In Conclusion
There is a myriad of factors that influence whether one should convert or not to Roth, such as medicare costs, tax bracket bumps, social security payments, and other retirement plans that this article doesn’t delve into. Converting to Roth during a market downturn though could be a decisive factor, especially if you are younger and time is on your side, giving markets plenty of time to rebound and drive back up your portfolio value. Besides tax savings, other key Roth benefits are as follows:
- There are no mandatory withdrawals upon reaching 72 years old.
- You can contribute to a Roth for as long as you like.
- Distributions aren’t counted as income.
- Tax-free legacy for beneficiaries.
Is a Roth conversion right for you?
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