How an IRA Could Be Used in a Down Market

Traditional IRAs are pretty common for people. In most cases, they've been opened when employees roll over their funds from a 401k into their own individual accounts without incurring a taxable event. A Traditional IRA helps out with this because, like a 401k, it's pre-taxed. This means that any money contributed is tax-deferred and therefore deductible from income. However, funds that are distributed down the line are taxed as ordinary income. In today's down market, investors are seeing their funds take a hit. However, owning a Traditional IRA might actually create an opportunity with a unique strategy: Roth Conversions.

What is a Roth Conversion?

A Roth Conversion is a process where funds from a pre-tax account are transferred into a "post-tax" account. A post-tax account is where after-tax money is held in a tax-free account like a Roth. Initiating this transfer requires paying those pre-tax dollars, but the transfer allows those funds to grow in the tax-free account. In addition, there is no 10% penalty for this transaction like normally for an early distribution before 59 1/2 years old. There are many strategies this can be used for, but almost all of them have the same idea: lowering their future tax bill.

Why is This Useful in a Down Market?

Let's throw a hypothetical scenario here. Suppose someone, Bob, had around $100,000 in his Traditional IRA. If he wanted to convert half of this, he could take $50,000 and transfer it into a Roth IRA. This transfer is taxable so he would normally pay taxes on the $50,000 for the year. Now let's say he decided not to move forward with that and left it as is. But later that year, the market went bad and his account dropped from $100,000 to $50,000. Bob decides he wants to convert half of this, but half of this portfolio is now $25,000. He decides to perform a Roth Conversion on this amount and now has $25,000 in the Traditional IRA and $25,000 in the new Roth IRA. Now let's suppose the market rebounds back to its original balance of $100,000 total. Assuming they were invested exactly the same as before, the funds would bounce back up to $50,000 in a traditional IRA and $50,000 in a Roth IRA. In the end, Bob is right back where he started, except half of the funds are in a tax-free account. This presents a huge opportunity to minimize his future tax bill and retain much of the wealth he's accumulated so far!

But There's a Price to Pay

This technique might not be a right fit for everyone for a couple of reasons. First of all, the amount that got transferred in this case, $25,000, would now become taxable. If Bob doesn't have the cash on hand, it's not going to be fun tax season. Secondly, it may not be worth paying taxes today. Similar to deciding between contributing to a Traditional IRA or a Roth IRA, it depends on what income & tax rates are today relative to what income & tax rates might be in the future. Bob could benefit from a Traditional IRA if these are lower in the future and the Roth IRA will benefit him if these are higher in the future. A Roth Conversion falls into very similar circumstances since it's a transfer from a pre-tax to a post-tax account. The transfer will most likely generate a tax bill, so deciding to move forward requires a thorough breakdown.

The Opportunity: Fewer Funds to Convert, Fewer Funds to Tax

So why consider this? The big opportunity this creates is taking advantage of paying taxes on less money. With his portfolio dropping in a down market, Bob may pay taxes on a lower balance and benefit from a potential bounce back in a tax-free account. Had Bob initiated half a conversion on the $100,000, he would be paying taxes on $50,000. Instead, the market drop allowed him to pay a lower tax bill on half of the funds ($25,000) and now he has even more money in a tax-free account. That can make a massive difference in building and retaining wealth in the future! It's an opportunity that only presents itself in a down market as Bob continues to contribute toward his portfolio. Overall, everyone needs to run the numbers to determine if this is the right fit for them. This process is also not easy as pushing a button, so always make sure to do this with a financial advisor & tax professional to see if this makes sense. But if it does, it may be a huge opportunity to lower that future tax bill!

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