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Take Advantage of Market Downturns to Reduce Tax on ROTH Conversions

06.06.16 | TAX Chat

While market downturns are never pleasant, if you have a traditional Individual Retirement Account (“IRA”), you should consider taking this opportunity to convert your traditional IRA to a ROTH IRA at a lower tax cost.

Traditional IRAs
The benefits of a traditional IRA are that contributions may be deductible, depending on your modified adjusted gross income (MAGI) and whether you participate in a qualified retirement plan, such as a 401(k). Also, funds in the account grow tax-deferred.

The downside is that you generally pay income tax on withdrawals at ordinary income tax rates, and, with only a few exceptions, you’ll face a penalty if you withdraw funds before age 59½. You will face an even larger penalty if you don’t take your required minimum distributions (RMDs) after age 70½. If you were not permitted to deduct your contributions, a portion of your IRA distributions will be allowed tax free and you will pay tax only on the income earned and capital appreciation of the IRA assets.

Roth IRAs
Roth IRA contributions, on the other hand, are never deductible. However withdrawals — including earnings and capital appreciation — are tax-free as long as you’re age 59½ or older and the account has been open at least five years. In addition, you’re allowed to withdraw contributions at any time tax- and penalty-free.

There are  also estate planning advantages to a Roth IRA. Since Roth IRAs are not subject to the RMD rules apply, you can leave funds growing tax-free for as long as you wish. Then distributions to whomever inherits your Roth IRA will be income-tax-free as well.

The ability to contribute to a Roth IRA, however, is subject to strict limits based on your MAGI. Fortunately, anyone is eligible to convert a traditional IRA to a Roth. The cost of converting is that you may have to pay income tax on the amount you convert.

Saving Tax
This is where the “benefit” of a stock market downturn comes in. If your traditional IRA has lost value, converting to a Roth now rather than later will minimize your tax hit. Plus, you’ll avoid tax on future appreciation when the market rebounds.

Of course, there are more ins and outs of IRAs that you will need to consider before executing a Roth IRA conversion. If I have piqued your interest, contact me at hzemel@berdonllp.com or your Berdon adviser to discuss whether a conversion is right for you.

Hal Zemel, a Tax Principal at Berdon LLP, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.