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A bear market is not just a time to crawl into your investing hibernation until the bear finally leaves; it is also an opportunity to take advantage of certain forces that work in your favor.
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One of those forces has to do with a Roth IRA conversion. As the Wall Street Journal recently noted, when the value of assets such as stocks and funds go down, the taxes on Roth IRA conversions often go down as well. This means that converting to a Roth IRA during a bear market increases your potential for asset growth and tax-free withdrawals.
For those who need a retirement plan refresher, a Roth IRA is a qualified individual retirement account that lets you grow your investments tax-free. You pay in money on which you have already paid taxes.
It’s the opposite of a traditional IRA or 401(k), in which you don’t pay taxes on the money you put in, but you do owe tax on the withdrawals. There’s also no required distribution from your Roth IRA, unlike a traditional IRA or 401(k), which requires you to start making withdrawals at age 72.
Roth IRA conversions have become increasingly popular over the past few years. Taxpayers reported 892,000 Roth conversions totaling nearly $17 billion in 2019, the WSJ reported, citing IRS data. That’s significantly more than five years earlier, when 489,000 taxpayers converted about $8 billion. The conversions have been especially popular with Americans who earn between $200,000 and $500,000 a year.
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As the name suggests, a Roth conversion involves moving assets from a traditional IRA to a Roth IRA and then paying income tax on the transfer. The tax bill can get quite high, depending on the dollar amount of assets being transferred. But converting when prices are falling – such as during the bear market – reduces your tax burden.
If the tax rate on the Roth IRA conversion is lower than the rate expected when the assets would be withdrawn, a conversion makes sense. On the other hand, if the tax rate at conversion is higher than the expected rate at the time of withdrawal, it may not be such a good decision.
This is why it is important to make Roth conversions during years when tax rates are low. Many financial advisers recommend doing partial Roth conversions over several years to avoid income that can push you into a higher tax bracket.
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