One simple investing move can set you up for huge returns and a minimal tax bill
In a year when both stocks and bonds are down, investors may be looking for anything that can set them up for future success. So far this year, the S & P 500 has shed nearly 20% and has entered bear market territory. Bond prices have fallen as well. Sectors that previously lifted the index such as technology and growth have slumped this year amid high inflation, recession fears and rising interest rates. One thing that can be smart in a down market is to convert amounts in traditional individual retirement accounts to a Roth IRA, a special type of retirement account where stocks grow tax-free. Typically, the money invested in a Roth IRA or Roth 401(k) is post-tax, meaning you’ve already paid the taxes on the amount contributed. This is different from a 401(k) or traditional IRA, in which the money is invested pre-tax, meaning that when you withdraw it in retirement you pay taxes. After you’ve paid the taxes on the investments in the Roth account, you do not owe anything else even when you later withdraw from it in retirement. That includes capital gains taxes, meaning that your investments could increase in value astronomically and you wouldn’t owe the IRS any more money. “If an ordinary person converted $20,000 or $30,000 from a retirement account into a Roth and they were able to pay the taxes themselves and they invested in growth stocks, in a 20-year period, that could grow really substantially,” said Tim Pagliara, chief investment officer of CapWealth. An extreme example of this is investor and Palantir Technologies founder Peter Thiel, who grew a Roth IRA from $2,000 to about $5 billion in about two decades. Best assets to convert It makes the most sense to convert beaten-down stocks that you ultimately believe in and see growing in the long-term. “There’s potentially a lot of individual assets that still have long-term growth prospects, but their valuations have slipped,” said Judson Meinhart, senior financial advisor and manager of financial planning for Parsec Financial. “It’s a good opportunity if you have specific positions like that in your portfolio to convert those.” After this year, technology stocks are top of mind. Even though shares of technology companies and especially megacap stocks have been dragged down, Wall Street is bullish on many of them over the long term. That includes names such as Apple , Microsoft and Alphabet . “What you can do is take advantage of the fact that it’s down in value and move those shares into your Roth IRA,” said Tim Steffen, director of tax planning at Baird. “The conversion cost is going to be less because the value of the stock is lower.” Other growth stocks have also been hit hard this year but could have a lot of future upside potential. One company that might fit the bill is Roblox , which has been hit hard but has a solid growth story, according to Delano Saporu, founder and CEO of New Street Advisors Group. He added that he’d also recommend investors look at areas like cybersecurity, which is set to grow over the next two decades and includes names like CrowdStrike and Palo Alto Networks . He’s also watching sports betting platforms, which he thinks has a tailwind of five to ten years of growth. “That’s another sector that I think will grow, especially as regulation starts to fall into place that allows more companies to operate in different states,” he said. Conversions aren’t limited to stocks. You can convert any traded asset, including bonds, mutual funds or exchange-traded funds. You can also target specific stocks – although you don’t have to convert entire positions if you don’t want to – or focus more on a dollar amount, depending on the tax bill you’re anticipating on the conversion. Rules of conversion Converting assets to a Roth IRA can get around some of the other limitations on the accounts. For example, you can still convert money into a Roth IRA if you’ve exceeded the income limit to contribute to such an account – in 2022, the modified adjusted gross income limit is $144,000 for those filing taxes individually and $214,000 for those married and filing jointly. Investors can also convert more than the contribution limit, which in 2022 is $6,000 for those under the age of 50 and $7,000 for those 50 and over. “You can do a conversion of any amount at any point,” said Steffen. “There’s no limitations on what you can and can’t convert.” Roth IRAs also do not have required minimum distributions, which kick in at a certain age for other retirement accounts. That means investors have more time to let money grow and can pass it on to family members after death without any additional tax bills. When a conversion makes sense Of course, before you decide to convert stocks or other assets to a Roth IRA, you should make sure you have enough money to pay the taxes for it and that it makes sense for you to do a conversion. Investors should also consider the bill they’ll have by converting assets into a Roth IRA now. For example, if doing so is going to create $100,000 of additional taxable income and you don’t have the money to pay that kind of tax bill, it might not make sense. Generally, financial advisors say a mix of pre- and post- tax dollar accounts make sense so that you can optimize your taxes as you draw down income in retirement. It also usually only makes sense to do a Roth conversion if you see your tax rate increasing in the future. If you’re near retirement or past your peak earning years and think your tax rate will go down, paying the bill now won’t save you any money. “Before you do anything, consult a tax professional or a financial professional,” said Eric Bond, founder and wealth advisor of Bond Wealth Management, adding that a wrong decision could cost you in the long term as a conversion can’t be undone.