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But every cloud has a silver lining, right? Well, I just looked outside and can see nothing but solid gray from horizon to horizon. So much for folk wisdom.
This weekend I got to wondering if there were any silver linings to last week's market meltdown. And I came up with one! It's not exactly broadly applicable, but it does go to show that it's an ill wind that blows no man good.
This could be a good time to convert your traditional IRA to a Roth IRA. Actually the ideal time was in 1998 when you could convert and spread the tax payments out over the next four years. But if you didn't do it then and have been left with the sinking feeling that maybe you should have, then now could be very much better than later.
Here's why. When you convert, you have to pay taxes due on all the growth that has occurred in your account up until the day of the conversion. That alone is enough to make the conversion a non-starter for most folks, but in the few circumstances where that does make sense, it's better to do the conversion when your portfolio is temporarily down because of the market slide.
For example, if you had done a conversion a month ago on a $50,000 account, you would have paid something like 28% of that $50,000 in taxes (depending on your tax bracket), which would be $14,000. Today, if that account were heavily weighted in tech stocks, it may be worth $35,000. Twenty-eight percent of $35,000 is only $9,800. A very significant tax savings to convert what is essentially the same thing from taxable to non-taxable status.
I said that this was not a broadly applicable silver lining. That's because for most people, a Roth conversion is at best economically neutral and, if mishandled, could actually cost you money. But if you can pay the taxes that are due on the conversion from spare cash rather than taking it out of the account (and paying a 10% penalty on the withdrawal), a conversion now could be attractive.
Say you had a $10,000 IRA and converting that would not put you into a higher tax bracket. Let's also assume that you are in the 28% bracket. Your taxes on the conversion would be $2,800. If you could swing that and still keep up your $2000 annual contributions, a conversion might be a reasonable idea.
There's a big caveat to that, though. What else could you do with that $2800? If you are a disciplined investor, you could take that $2800 and invest it in a good buy-and-hold strategy. By the time you are ready to retire, that $2,800 could generate enough after tax cash to pay part or all of the taxes due on your IRA withdrawals.
So how disciplined are you? If you aren't (be honest), using that $2800 to buy a future of tax free returns may be far better use of the money than, say, a trip to Ixtapa.
It's very tempting to take the cash out of your IRA -- the idea of tax free returns smells better than chocolate to some people -- but reducing your account by that much (remember, you have to pay the 10% penalty on the money you take out to pay the taxes with) is a mortal blow. Do that, and the amount you can safely withdraw from the Roth would be lower than what you end up with after taxes from a traditional IRA. (Note: That may not be true if you live in a state with very high state income taxes that also excludes Roth distributions from tax.)
This column can't possibly go into all of the ins and outs of Roth conversions (although we do have some excellent information on them in our Retirement and Tax Areas.) Nor could I describe every specific situation in which it might make sense. But if you have been considering a conversion, now would be the time to investigate it thoroughly and see how it would work for your particular situation. If your account is large, you would probably be best served by consulting a professional financial planner who can help you assess the impact.
OK, so maybe this is more like a bronze lining. Hey, I tried.