That’s why a Roth IRA conversion can pay off in a bear market

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Rising inflation, rising interest rates and the war in Ukraine have triggered continued stock market volatility. But there could be a plus point: the ability to save money on a Roth conversion.

The strategy allows higher earnings to evade the earning limits for Roth Individual Retirement Account contributions, capped at $ 144,000 modified adjusted gross income for single investors and $ 214,000 for married couples depositing together in 2022.

Here’s how it works: Investors pay what’s known as non-deductible contributions to a pre-tax IRA before converting funds into a Roth IRA, kicking off tax-free growth.

It’s almost like putting that Roth IRA up for sale.

Ashton Lawrence

Partner at Cardellino Wealth Management

The trade-off is that Roth conversions trigger an advance tax bill on contributions and earnings. The larger your pre-tax balance, the more you will need to convert.

And the latest stock volatility could be an opportunity for investors looking to a Roth conversion, said certified financial planner Ashton Lawrence, a partner at Goldfinch Wealth Management in Greenville, South Carolina.

“It’s almost like putting that Roth IRA up for sale,” he said.

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For example, let’s say you have a traditional pre-tax IRA worth $ 100,000, you like investments, and when the whole market goes down, the value drops to $ 65,000. You can save money by converting $ 65,000 instead of the original $ 100,000.

Major stock market averages have declined over the past five weeks, dive Tuesday morning after three days of heavy sales.

During the first quarter of 2022, Roth’s conversions increased by 18% compared to the first quarter of 2021, according to data from Fidelity Investments.

Advance tax bill

While a Roth conversion during a stock market decline may seem tempting, experts say the decision is about more than just asset values.

Marianela Collado, a Plantation, Florida-based CFP and CPA at Tobias Financial Advisors, says you need to consider how many years it will take to break even on that prepaid tax bill.

You will also need to weigh the combined balances across IRA accounts, due to the so-called “proportional rule,” which takes into account total funds before and after taxes to calculate the invoice.

“It’s one of those things you can’t look at in a vacuum,” Collado added.

The five-year rule

Additionally, while Roth IRAs typically offer tax-free withdrawals and penalties at any time for contributions, there is a exception for conversions known as the “five-year rule”.

Investors must wait five years before they can withdraw their converted balances, regardless of their age, otherwise they will incur a 10% penalty. The timeline begins on January 1 of the year of conversion.

Increase in adjusted gross income

Another possible downside to a Roth conversion is the potential increase in adjusted gross income that year, which could trigger other problems, Lawrence said.

For instance, Medicare Part B calculates monthly premiums using the modified adjusted gross income, known as MAGI, from two years earlier, which means that 2022 income could create higher costs in 2024.

The base amount for Medicare Part B in 2022 is $ 170.10 per month, and payments increase once the MAGI exceeds $ 91,000 or $ 182,000 for joint custodians.

For 2022, the Medicare Part B supplement is $ 578.30 once MAGI exceeds $ 500,000 for singles or $ 750,000 for couples who present together.

“It’s like a balloon,” explained Lawrence. “If you squeeze it on one end, you blow it up somewhere else.”