The stock market has been on a rocky ride this year, experiencing both record lows and all-time highs in just a matter of months.
After an impressive comeback over the summer, the market has been on a downhill slide since early September. The Dow Jones Industrial Average (DJINDICES:^DJI) recently tumbled by roughly 500 points, marking the index's worst day in approximately two weeks. These signs could indicate another market crash is on the way, and it's important to ensure you're as prepared as possible.
Although a market downturn isn't necessarily a positive thing, there is a bright side to a potential crash: It's the perfect opportunity to convert to a Roth IRA and save money.
Why a Roth IRA?
The biggest advantage of a Roth IRA over a traditional IRA or 401(k) is that you won't owe income taxes on your withdrawals in retirement. However, you do need to pay taxes on your initial contributions.
When you roll your investments over from a tax-deferred account (such as a 401(k) or traditional IRA) to a Roth IRA, you'll need to pay taxes on the amount you're converting. After all, Uncle Sam still wants his money, so converting to a Roth IRA won't let you get out of paying taxes altogether.
The reason a market downturn is the perfect opportunity to convert is that your investments won't be worth quite as much. Normally, of course, you don't want to see your investments lose value. However, a lower account balance when you convert to a Roth IRA means you'll also have a smaller tax bill.
Depending on just how much cash you're rolling over, you could potentially save thousands of dollars in taxes by making the conversion when your account balance is lower.
Is converting to a Roth IRA the right move for you?
There are a couple of scenarios where moving your money to a Roth IRA might make financial sense. For one, you can save money in retirement because your withdrawals won't be subject to income taxes. If you expect to be in a higher tax bracket when you retire, you could come out ahead by paying taxes now when you're in a lower bracket.
Another reason to consider converting is if you plan to work past age 72. With a traditional IRA or 401(k), you're generally required to start taking distributions from your account once you turn 72 years old, even if you're still working. Between your earned income and your retirement account withdrawals, you could potentially be in a higher tax bracket. With a Roth IRA, though, you're not required to start taking distributions at any age, so you can continue working past age 72 without withdrawing your savings until you're ready.
When it's not the right time to convert
Despite the advantages of converting to a Roth IRA, it's not necessarily the right move for everyone. Although you can potentially save a significant amount of money in taxes by converting during a market downturn, you could still face a hefty tax bill depending on how much money you're rolling over. If money is tight right now, that could be a problem.
In that case, you may be better off contributing to an emergency fund, or simply continuing to save in your current retirement account. Market downturns are great opportunities to invest more because stock prices are lower, so you can get more for your money. Regardless of what type of account you're contributing to, saving more is a good idea.
Moving your investments over to a Roth IRA can be a smart move in some instances, and it could potentially save you thousands of dollars in taxes. By weighing the pros and cons and deciding whether it's the right move for you, you could save money both now and in retirement.