The U.S. economy has taken a beating recently due to the coronavirus pandemic, and millions of Americans have watched their retirement savings drop significantly.
One of the more stressful aspects of watching this market crash unfold is that there's not much anyone can do to stop it. If your investments have taken a hit, there's little you can do other than brace yourself to weather the storm and keep reminding yourself that the economy will recover eventually.
If you're determined to do something to improve your finances, though, there's one smart move you can make: convert your traditional IRA to a Roth IRA.
There's no better time to convert to a Roth
Traditional IRAs and Roth IRAs are similar in many ways, but they differ in how your contributions are taxed. With a traditional IRA, you won't pay taxes when you make the initial contributions, but you will pay taxes when you withdraw your money. A Roth IRA is the opposite: You'll pay taxes upfront, but your withdrawals are tax-free.
When you convert a traditional IRA to a Roth IRA, you'll need to pay income taxes on your account balance during the year you make the switch. Depending on how much money you have stashed in your account, that could be a hefty tax bill.
However, right now is the perfect opportunity to convert because your account balance is likely much lower now than it was a couple of months ago. That means your tax bill will also be smaller when you make the conversion. If you wait until the market starts to recover and your investments begin to increase in value again, you'll need to pay more in taxes when you switch to a Roth.
How a Roth IRA could save you cash
Historically, the market has always recovered from every crash it ever experienced. That means it's very likely your investments will recover their value given enough time. Although you will face taxes now by converting to a Roth, it's likely your investment gains from now until retirement will outweigh that tax bill. And as a bonus, you won't need to pay taxes on your Roth withdrawals once you reach retirement. If you stick with a traditional IRA, you could end up paying more in taxes on your withdrawals in retirement than you would by converting to a Roth IRA now.
Of course, many families are struggling financially right now and can't afford to pay hundreds or thousands of dollars in taxes by converting to a Roth IRA. The last thing you should do is cash out your emergency fund to pay these taxes, especially if money is tight. The good news, though, is that as a result of the recently passed coronavirus stimulus bill, investors can withdraw up to $100,000 from their retirement accounts penalty-free. So if you want to convert to a Roth IRA but can't afford the tax bill, you may be able to use funds from your traditional IRA or 401(k) to cover the cost.
While withdrawing any money from your retirement fund before you retire isn't typically recommended, it's an option to consider. Withdrawing your savings isn't ideal, but it may be a small price to pay if it could help you save even more down the road by avoiding taxes in retirement. Just make sure that after you make the conversion, you leave your investments alone to give them as much time as possible to grow.
The stock market may be going through a rough patch, but there is a silver lining. Right now is the perfect opportunity to convert to a Roth IRA, and doing so could potentially save you thousands of dollars in taxes down the road.