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As investors wrestle with tariff-induced stock market volatility, there could be a tax-planning opportunity. But it’s not right for all investors, experts say.
The strategy, known as “Roth conversions,” transfers pretax or nondeductible individual retirement account money to a Roth IRA, which starts future tax-free growth. The tradeoff is paying upfront taxes due on the converted balance.
This planning move has been gaining popularity. As of Dec 31, the volume of Roth conversions increased by 36% year-over-year, according to the latest data from Fidelity Investments.
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Roth conversions are especially attractive when the stock market drops, according to certified financial planner Ashton Lawrence, director at Mariner Wealth Advisors in Greenville, South Carolina.
Here’s why: Amid market volatility, you can convert a smaller balance and pay less upfront taxes. When the market recovers, you’ll secure tax-free growth in the Roth account, Lawrence said.
Still, there are some key factors to consider before converting funds, experts say.
Consider your tax rate
When weighing Roth conversions, “the single biggest factor” should be your current marginal tax rate vs. your expected rate when you withdraw the funds, said George Gagliardi, a CFP and founder of Coromandel Wealth Management in Lexington, Massachusetts. (Your marginal rate is the percent you pay on your last dollar of taxable income.)
Typically, you should aim to time planning moves that incur taxes — including those from Roth conversions or future withdrawals — when rates are lower, experts say.
But boosting your adjusted gross income can lead to other tax consequences, such as higher Medicare Part B and Part D premiums. That’s why it’s important to run tax projections before converting funds.
Cover the upfront taxes
When completing a Roth conversion, you’ll owe regular income taxes on the converted balance, which should also factor into your decision, Lawrence said.
Generally, you should aim to pay those taxes from other sources, such as savings. “The last thing you want” is to use part of the converted balance to cover taxes because then there will be less to transfer to the Roth account, he said.
Discuss your legacy goals
Another factor could be your legacy goals — including whether heirs, such as adult children, could inherit part of your pre-tax retirement balance, experts say.
Since 2020, certain heirs must follow the “10-year rule,” which stipulates that inherited IRAs must be depleted by the 10th year after the original account owner’s death. This applies to beneficiaries who are not a spouse, minor child, disabled, chronically ill or certain trusts.
In some cases, clients pay taxes upfront via a Roth conversion to spare their future heirs from the bill, Lawrence said. Alternatively, some pass along the tax liability when heirs are in a lower tax bracket.
“We know that Uncle Sam is going to get his fair share, but we can be smart about it,” he added.
