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One Smart Move: A bear market is the best time to ‘convert’ to a Roth IRA. Here’s why

April 8, 2020, 10:00 AM UTC
Quarterly Investment Guide 2020-6yellow_article
Illustration by Jamie Cullen

This article is part of Fortune‘s quarterly investment guide for Q2 2020.

Courtney Knoll, an associate professor of accounting at UNC–Chapel Hill’s Kenan-Flagler Business School and associate director of the UNC tax center, likes to boast about an unusual number.

“I have a zero balance in my traditional IRA,” she says with a smile.

That may sound strange coming from a professor with a Ph.D. in accounting, but there’s a method to her madness. Years ago she took advantage of a somewhat obscure provision called a “backdoor conversion.” It’s a perfectly legal strategy that allows people whose income is too high to allow them to contribute directly to a Roth IRA to donate to a regular IRA, then every year “convert” that donation and move it into a Roth IRA. And, says Knoll, if you have a traditional IRA and have never done a conversion, a bear market is one of the best times to take advantage of this arrangement because values are lower, so your tax bill will be too.

Ed Slott, an IRA specialist and CPA in Rockville Centre, N.Y., agrees. His take? “People don’t like the name. It sounds like you’re up to something,” he jokes. But in reality, for the subset of investors who can afford it, a conversion right now is “a smart move.” Tax rates are so historically low (and, in his view, bound to go up given the recently passed stimulus package) that “those days of taking an IRA deduction aren’t worth it anymore,” he says, referring to a traditional IRA, in which your contributions (subject to certain limits) are tax deductible. “Everyone should be looking at converting [to a Roth] given the low values and the low tax rates.”

One added bonus: Given the Treasury Department extension, you now have until July 15, 2020, to make an IRA contribution for 2019.

How do Roth IRAs work?

First, the basics. Roth IRAs are beloved by CPAs for a few simple reasons. You put in money after-tax, but after it’s in, the balance grows tax-free. So even if your balance grows from a few thousand dollars upon inception to a million or more by the time you retire, your distributions upon retirement will be totally tax-free. So, if you expect to be at a higher tax bracket upon retirement than you are now, Roths are considered a very good deal.

And unlike regular IRAs, Roths do not have required distribution mandates, so you can let your money grow as long as you like. But Roths do have strict income limits. For this year, anyone making more than $139,000 as an individual, or $206,000 for a married couple filing jointly, cannot contribute to a Roth. However, somewhat inexplicably, it’s perfectly legal for anyone making over that amount to contribute to a regular IRA (a max of $6,000 this year, or $7,000 if you are 50 or over and doing a “catch-up” contribution), then “convert” to a new or existing Roth where—voilà!—the balance grows tax-free.

Why is this a particularly good strategy during a bear market? As Knoll explains, if the money inside your traditional IRA has never been taxed, you will need to pay some taxes when you ultimately convert. “That tax due is in part based on the value of the investments inside at the time of conversion,” she explains. “So if I convert when values are pummeled, my tax hit is smaller, and once everything recovers, that appreciation never gets taxed.”

That said, there are several considerations to be aware of.

  • First, says Slott, make sure you have enough money to pay the tax bill when it comes due next year. It is not tax-efficient to use money from the account you are converting to pay this. Here’s why: if your plan is to convert $100,000, but you hold back $30,000 to pay the tax, then you will only be converting $70,000, explains Slott. You are still paying tax on the full $100,000, and in addition if you are under age 59½, the $30,000 that was not converted, will now be subject to a 10% early distribution penalty in addition to the tax. If your account is substantial or the tax bill is too high, Slott recommends converting the balance a portion at a time to spread out the hit.
  • Slott recommends clients wait 30 days after contributing to a regular IRA before converting it to a Roth. Though there’s no rule that explicitly mandates this, he thinks it’s wise to have a monthly statement showing a balance in your regular IRA, so it’s clear there were two separate transactions.
  • The rules used to state that once you were over age 70.5, you could no longer contribute to an IRA. Now that has changed—you’re no longer limited by age—but there’s one point that trips people up, notes Slott. You still must qualify by having qualified compensation, and pension income does not count.
  • Slott says while you used to be able “undo” such conversions, now they are permanent. Once you convert, you’ll owe the tax. So make sure to do the math first.
  • Roths require that you not withdraw money for at least five years, so this is something to keep in mind if you are nearing retirement age. If you’ll need to access the money within five years, this isn’t a good option, says Slott.
  • If you had previously rolled your 401(k) into a regular IRA, you should be able to convert that too. Just remember: Calculate your tax liability first.
  • And one final caveat: this description assumes you only have one traditional IRA. The tax calculation at conversion takes the balance of all traditional IRAs into account not just the one that is being converted, notes Knoll. So be sure to talk to your accountant or tax professional to review the specifics of your own situation.

And if you end the year with a zero balance in your traditional IRA? At least it’s something you can feel good about.

More from Fortune’s Q2 investment guide:

5 rules to guide your investing decisions during the coronavirus pandemic
Market preview: What to remember as we move past a quarter to forget
—Chasing returns: Why ‘inside the tent’ assets like corporate debt may be poised to outperform
—Q&A: State Street’s Lori Heinel on where she sees beaten-down buying opportunities during coronavirus
Best stocks to buy now: These 5 names will weather the coronavirus pandemic
The health of the economy in 7 charts
How to adjust your 401(k) during a bear market

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