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Soaring inflation, interest rate hikes and the war in Ukraine have sparked ongoing stock market volatility. But there may be a bright spot: the chance to save money on a Roth conversion.
The strategy allows higher earners to sidestep the earnings limits for Roth individual retirement account contributions, capped at $144,000 modified gross income for single investors and $214,000 for married couples filing together in 2022.
Here’s how it works: Investors make what’s known as non-deductible contributions to a pre-tax IRA before converting the funds to a Roth IRA, kickstarting tax-free growth.
The trade-off is that Roth conversions trigger an upfront tax bill on contributions and earnings. The bigger your pre-tax balance, the more you’ll owe for the conversion.
And the latest stock volatility may be an opportunity for investors eyeing a Roth conversion, said certified financial planner Ashton Lawrence, partner at Goldfinch Wealth Management in Greenville, South Carolina.
“It’s almost like getting that Roth IRA on sale,” he said.
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For example, let’s say you have a pre-tax traditional IRA worth $100,000, you like the investments and when the entire market goes down, the value drops to $65,000. You can save money by converting $65,000 rather than the original $100,000.
Major stock market averages have dropped for the past five weeks, dipping on Tuesday morning after three days of heavy selling.
During the first quarter of 2022, Roth conversions were up by 18% compared to the first quarter of 2021, according to data from Fidelity Investments.
Upfront tax bill
While a Roth conversion during a stock market dip may seem appealing, experts say the decision involves more than asset values alone.
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 upfront tax bill.
You’ll 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.
The five-year rule
What’s more, 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 balances, regardless of their age, or they will incur a 10% penalty. The timeline begins on Jan. 1 on the year of the conversion.
Boosting 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.”