Time To Think About Roth Conversions

We have written several blogs over the years on Roth IRAs.  Today though, they have even more importance given the downturn in the market over the past couple of months.  As a quick refresher, a Roth IRA provides tax-free growth on after-tax contributions.  When funds are withdrawn, normally after attaining the age of 59 ½, qualified distributions are tax-free. 

There are two ways to introduce money into a Roth IRA.  The first is to contribute to a Roth IRA.  Investors also can execute what is referred to as a Roth conversion.  Roth conversions can be completed by anyone, regardless of age or income, with minor exceptions.  When executing a Roth conversion, an investor takes a distribution from their traditional IRA and “converts” those assets to a Roth IRA.  In the eyes of the IRS, this distribution is a taxable event and included in your taxable income for the calendar year in which the conversion is completed.  An investor can do either a partial conversion or a full conversion of their traditional IRA assets. 

The reason a Roth conversion is potentially more advantageous currently is because many of the assets we hold in our traditional IRAs today are down dramatically from their highs in January of this year.  If you believe that in the long–term your IRA assets will grow substantially, converting them to a Roth IRA is a smart and strategic move.  Let’s take an example: 

You purchased shares of Alphabet Inc. (GOOG) inside your traditional IRA sometime in early February 2020.  You paid approximately $1515 per share.  Today GOOG is trading for approximately $1270 per share, down 16% – 17% from your initial purchase price.  You still believe GOOG is a great long-term hold in your portfolio.  So, you execute a partial in-kind Roth conversion of those shares of GOOG.  Technically, you distribute the shares of GOOG out of your traditional IRA (transferring shares from one account to another is known as an in-kind transfer – you don’t actually sell the shares).  You will be taxed on today’s value of those shares when you file your 2020 tax return – $1270/share times the number of shares you took out of the IRA.  You then “convert” those same shares by depositing them into your Roth IRA.  Now, the future appreciation of those shares will accrue tax-free inside your Roth IRA and when you take distributions from the Roth IRA, assuming they are qualified distributions, the distributions will also be tax-free.  If you had left the GOOG shares inside your traditional IRA, you would have achieved the same growth in GOOG that you did inside your Roth IRA, but those future distributions from your traditional IRA will be treated as taxable income as opposed to tax-free income! 

Keep in mind that a Roth conversion is a taxable event.  So, before making the conversion, consider your current tax situation and consult with your tax advisor.  However, considering the impact the economic shutdown has had on many individuals’ income, its likely your tax bracket this year will be lower than a “normal” year.  If so, converting some assets over to your Roth IRA may not have a significant impact on your 2020 income tax liability.