If you’re considering a Roth conversion, stock market drops may make the strategy more appealing, according to financial experts.
While the popular move, allowing higher earners to bypass income limits for Roth individual retirement account contributions, was in peril as House Democrats passed Build Back Better, the spending package stalled in December.
Nevertheless, the move may be attractive amid stock market volatility triggered by the Russia-Ukraine conflict, said certified financial planner Jordan Benold, partner at Benold Financial Planning in Prosper, Texas.
Roth conversions may trigger levies on pretax contributions or earnings, so investors will need a plan for covering the bill.
For example, let’s say you have a pretax traditional IRA worth $100,000, you like the investments, and when the entire market goes down, the value drops to $65,000.
“That might be an opportune time to do it,” Benold said, explaining how you’ll pay taxes to convert $65,000 rather than the original $100,000. But you need to weigh more than asset values alone.
“You need to be mindful of whatever taxes you’re going to incur, based on the conversion,” said Ashton Lawrence, a CFP with Goldfinch Wealth Management in Greenville, South Carolina.
If you’re willing to pay upfront taxes on a Roth conversion, you may project how many years it will take to break even, said Marianela Collado, a CFP and CPA at Tobias Financial Advisors in Plantation, Florida.
You also need to weigh combined balances across IRA accounts, because of the so-called “pro-rata rule,” which factors in your total pre-tax and after-tax funds to calculate your bill.
“It’s one of those things that you can’t look at in a vacuum,” Collado added.
Watch for the five-year rule
While Roth IRAs typically offer tax and penalty-free withdrawals anytime for contributions, there is an exception for conversions known as the “five-year rule.”
Investors must wait five years before they can withdraw converted balances, regardless of their age, or they will incur a 10% penalty. The timeline begins on Jan. 1 on the year of the conversion.
Increasing adjusted gross income
Another possible downside of a Roth conversion is the potential to increase that year’s adjusted gross income, which may trigger other issues, Lawrence said.
For example, Medicare Part B calculates monthly premiums using modified adjusted gross income, known as MAGI, from two years prior, which means 2022 income may create higher costs in 2024.
The base amount for Medicare Part B in 2022 is $170.10 per month, and payments increase once your MAGI passes $91,000 or $182,000 for joint filers.
For 2022, the top Medicare Part B surcharge is $578.30 once MAGI exceeds $500,000 for single filers or $750,000 for couples filing together.
“It’s like a balloon,” Lawrence explained. “If you squeeze it at one end, you’re going to inflate it somewhere else.”