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What is a Roth IRA Conversion?

One possible way to take advantage of stock market downturns is to look into converting your Traditional IRA to a Roth IRA via what is known–understandably–as a Roth IRA conversion.

How does it work?

As we know, the advantage of a Roth IRA over a traditional IRA is that distributions from a Roth IRA are not taxable as income. In a Roth IRA conversion, what happens is that you rollover the funds from your traditional IRA into a Roth IRA, and the amount of the rollover is added to your taxable income for the year.

In essence, you’re being taxed now on the current value in order to make your future distributions nontaxable. This can make a lot of sense for investors who are currently in a lower tax bracket than they expect to be in during retirement.

And I can’t think of a better time to execute a Roth conversion than at a time like this when your traditional IRA is likely worth 30-50% less than it was at the beginning of the year (thereby making the currently-taxable amount much smaller).

How do you do a Roth conversion?

In order to execute a Roth conversion, you have two options:

  1. Rollover: You can elect to take a distribution from your traditional IRA, and then roll that amount over into a Roth IRA within 60 days.
  2. Transfer:  You can inform the trustee of your traditional IRA (that is, your brokerage firm/bank/etc.) to transfer the money directly into your Roth IRA.

It’s important to know that you must rollover the same property that you received from your traditional IRA. In other words, if the distribution from your traditional IRA included shares of stock, you must roll those shares over rather than selling them and rolling over the cash.

Can you do a Roth conversion from a 401(k)?

Yes. As of 2008, investments from any of the following types of retirement plans are eligible for a Roth conversion:

Who is eligible for a Roth IRA conversion?

  • You must not be married filing separately. [Note: If you are married filing separately, but you didn’t live with your spouse for any part of this year, then you could still be eligible if you meet the other requirements.]
  • If you’re currently age 70.5 or older, and are taking required minimum distributions from your traditional IRA, these distributions cannot be rolled over as a part of a Roth conversion.
  • If you inherited an IRA from anybody other than your spouse, you cannot convert that IRA into a Roth IRA.

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