Many people get upset when the stock market plunges. Being unhappy about your investments suddenly losing a great deal of value is certainly understandable: No one enjoys discovering their portfolio has lost value.
However, if you have a properly constructed investment plan, you may not need to be upset, because stock market declines also represent opportunities. When markets drop, stocks can be considered “on sale.” The less a stock is valued, the more you can buy with the same amount of money. This is why savvy investors frequently invest more during a market downturn.
Less commonly recognized, however, is another significant upside: Market downturns are often a good time to set yourself up for tax relief in retirement. Consider the situation in 2022, when Nvidia (NVDA) lost 50% of its market value. If you happened to own Nvidia stock, you might have been tempted to be upset about this. However, a seasoned investor will more likely see the slump as a strategic tax opportunity.
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Losses aren’t losses until you sell
Despite its loss in valuation, when a stock declines, you haven’t actually lost anything. If you had 10 shares of Nvidia before its value dropped, you still have 10 shares afterward. You lose something only if you sell when the value of the stock is lower than when you purchased it. If you were to hold the stocks and patiently wait for their value to potentially rise again, your “losses” wouldn’t actually be losses.
However, from a tax strategy standpoint, those losses on paper can allow for greater gains than otherwise would have been possible. If you’re holding those 10 stocks inside a traditional IRA, you bought them with tax-deferred money. Because you didn’t have to pay taxes on the money you used to buy the stock, you were likely able to buy more than you otherwise could have.
That purchase also created a future tax bill. When you retire and begin taking distributions, you will pay taxes on the income you realize from those withdrawals. The real problem with this situation is that there is no guarantee that tax rates when you retire will be as low as they are today. In fact, it’s likely they’ll be higher.
A different kind of debt to pay
As financial advisers, we often badger our clients to pay off their debts, and for the most part they listen. However, they often fail to consider the debt (tax bill) you assume when you have a tax-deferred retirement account. An IRA or 401(k) can be thought of as deferring your tax bill from the government in that you aren’t charged taxes now, but will be later.
Current tax rates were established by the Tax Cuts and Jobs Act. Some of the TCJA’s provisions are set to expire at the end of 2025 unless Congress and the president act. On expiration, tax brackets and rates will reset to the higher levels of taxation it supplanted.
By converting the depressed-value stocks in your IRA to a Roth IRA, you short-circuit those tax increases. You pay current tax rates on the current value of the assets you convert, but you won’t pay taxes — income or capital gains taxes — when you withdraw from the Roth in the future, as long as the amount converted is not withdrawn for five years.
One main concern when performing Roth conversions is that the conversion counts as income and could land you in a higher tax bracket. However, consider this: If you’re currently in the 22% tax bracket, and your Roth conversion moves you to the 24% bracket, that’s still a lower tax bill than the 25% bracket you likely face in the future if all other factors, such as your income, remain the same.
Don’t forget the kids
It’s clear that Roth accounts represent a potential for tax savings — and not just for you. Your heirs can also benefit. If you leave $1 million in IRAs to your children, they will generally be required to empty the IRAs within 10 years of your death. If you die in your 80s and your kids are in their 50s, they’re likely in the highest-earning years of their career and will now have to realize significant additional, taxable income.
That could force them into a higher tax bracket and, therefore, cause them to pay more in taxes on the withdrawals unnecessarily. By converting your IRA to a Roth, your kids will inherit it tax-free.
For many, there are a number of clear advantages when considering Roth conversions. However, everyone’s situation is unique. It’s important to sit down with a financial adviser and a tax professional to determine if a Roth conversion is right for you.