Investor Column | Is now a good time to convert to a Roth IRA?

Recent turbulent markets have caused some investors to look for ways to help “soften the blow” of negative returns in their portfolios. One tax strategy that frequently comes to mind: converting one’s traditional IRA to a Roth IRA. Is that a good idea?

While a Roth IRA conversion can be a very effective tax strategy when used properly, it’s often misunderstood, as is the case above — when investors believe it may help mitigate losses they may be experiencing in their portfolios. It won’t.

First, the basics:

• Roth IRA assets, like traditional IRA assets, grow tax-free.

• Unlike a traditional IRA, there is no tax deduction for Roth contributions.

• Withdrawals/distributions from Roth IRAs are tax-free.

And because taxpayers got a deduction along the way for making contributions to a traditional IRA account, when they later convert assets out of that account (and into a Roth IRA), the IRS wants them to “un-do” that deduction. In other words, every dollar coming out of a traditional IRA and into a Roth IRA will generate taxable income as though a paycheck was received (aka “ordinary income”).

It’s important to note is that realized capital losses (e.g. portfolio holdings sold at a loss) can’t be used to offset “ordinary income.” Such losses can only be used to offset realized capital gains (e.g. portfolio holdings sold at a gain). If there are losses left over after all gains are used up, taxpayers can generally deduct up to $3,000 of losses in any tax year. Any unused losses can then be carried over into future tax years.

So if a Roth IRA conversion can’t offset portfolio losses, when DOES converting to a Roth IRA make sense? Some examples:

You expect taxes to go up

Since Roth IRA conversions create taxable income, if you believe taxes will be higher in the future and can afford to pay the taxes now, it may make sense to convert your traditional IRA to a Roth IRA. By doing so, you won’t have to take the required minimum distributions required for traditional IRAs at Age 72, and future Roth IRA distributions will be tax-free.

You have current operating losses

If you are a small business owner who has had a big downturn in “ordinary income” this year, converting to a Roth IRA may absorb some of these losses and still not raise your taxes as much as it would have in a normal tax year.

You don’t want your kids to inherit your traditional IRA

The SECURE Act passed in 2019 requires that non-spouse beneficiaries of inherited IRAs must take all distributions from the account within a decade. If you don’t want to leave your heirs with a big tax bill from taking those distributions, it might make sense to convert to a Roth IRA.

Unintended consequences of Roth IRA conversions

Since Roth IRA conversions usually create higher taxable income in the year they happen, without proper tax planning, one may experience:

• Higher Medicare premiums for a year or two after the Roth IRA conversion.

• More tax on Social Security benefits.

• A 3.8% Medicare surtax on net investment income, if the income tax bracket gets pushed high enough.

• Realized capital gains on a taxable investment portfolio could be taxed at 15-20%, versus 0% for taxpayers in lower tax brackets.

In other words, extreme care should be used when contemplating such a move.

Roth IRA conversions can be a powerful tax planning tool – when used under the right circumstances. But each individual’s tax situation is different, and this is not a “one size fits all” strategy, so it’s critical to consult a qualified tax professional first before moving forward.

Karin Grablin is with SRQ Wealth, One North Tuttle Avenue, Sarasota, FL 34237, 941-556-9004., www.srqwealth.com. Securities offered through Cetera Advisor Networks LLC, Member FINRA/SIPC. Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor. Cetera is under separate ownership from any other named entity. This article is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought. For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice. Converting from a traditional IRA to a Roth IRA is a taxable event.