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While a down market may not be a fun time for investors, there are some bright spots and opportunities to be had. Stock market drops like we’ve seen recently might make a Roth IRA conversion more appealing as a strategy for investors.

Should you consider converting a traditional IRA to a Roth during a down market? There are a few things to consider.

What is a Roth conversion?

When you have a traditional IRA, those are pre-tax dollars that you’re investing. While the money grows tax-free in the IRA, when you later go to take a withdrawal, every dollar you pull will be taxed at your current rate for income (not capital gains).

With a Roth IRA, you invest already-taxed dollars, which not only grow tax-free in the Roth, but are tax-free (along with any gains) whenever you withdraw them, as long as you are at least 59½ and follow a few other rules.

So, there is a lot of value to a Roth. However, when you convert a traditional IRA to a Roth, you need to turn those pre-tax IRA dollars (and any gain to date) into post-tax Roth dollars at the time. That means when you trigger a Roth conversion, you’ll be responsible for paying that year the tax due on any pre-tax contributions or earnings within the traditional IRA.

Conversions in a down market

When the market has dropped, it’s likely your IRA value has dropped along with it. Since the value of your IRA has gone down, you’ll be paying less taxes on the current value than you would have a few months ago when the market (and your IRA’s value) were higher.

That suggests you can probably convert a larger portion of your IRA in a down market than you could in years when the market is up.

It’s important to work with both a financial adviser and your tax professional to determine not only the amount of tax you’ll owe during the year that you perform the Roth conversion, but also how long it would potentially take you to break even.

Pros of a Roth conversion

Converting from a traditional IRA to a Roth has many potential benefits for investors. As noted above, because a Roth IRA allows for dollars to grow tax-free, all the growth is also tax-free.

There are also no RMDs, or required minimum distributions, on a Roth IRA. With a traditional IRA or 401(k), you have a set minimum you must withdraw each year once you hit the age of 72, but Roth IRAs do not have this requirement.

Tax rates are still relatively low, historically, which means now is as good of a time as any for a Roth conversion, from a tax perspective.

Another benefit of having a Roth IRA is that it gives you a different “bucket” of income to pull from in an effort to keep your taxes as low as possible during retirement.

Roth IRAs also benefit your spouse and heirs at inheritance time, as the tax-free benefits pass along to them in various ways, depending on the time limit and amount, and their relationship with you, the deceased.

A few cautions

Roth IRA conversions have other costs. There’s the five-year rule, where you must wait five years after a conversion before making a withdrawal or else you could incur a 10% penalty. Keep in mind that this five-year rule only applies to those who are younger than 59½.

Triggering a Roth conversion will also increase your adjusted gross income (AGI) that year, which could increase your tax rate that year and possibly affect other issues, such as raising the cost of Medicare premiums (which go up for those with higher AGIs).

The best way to determine if a Roth conversion is the right move for you during the down market is to work with a financial adviser and a tax professional so you can get feedback on your specific financial situation.

© 2022 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.