For IRAs, an Upside to Stocks Going Down

Undoing a Roth IRA conversion isn’t the only way retirement savers can benefit from falling stock prices. A bear market also can be a great time to go in the opposite direction and convert a traditional IRA to a Roth account.

The compelling reason to convert now: The combination of depressed stock prices and capital losses are likely to make the cost of conversion the lowest it’s been in years.

When you convert an IRA, you must pay income tax on the value of the assets transferred into the Roth account. The more those assets have declined in value, the less you’ll owe in taxes.

For example, say you put $1,000 into a traditional IRA in March 2000 and invested it in a Standard & Poor’s 500 index mutual fund. That investment would be worth just $630 as of the end of August, according to Ibbotson Associates, a Chicago-based market research firm.

Converting that IRA into a Roth account today would cost $189 in federal taxes, assuming you’re in the 30% bracket--about one-third less than if you had converted the account when it was still worth $1,000.

In addition, if you have realized capital losses in your taxable investment accounts, those can be used to offset even more of the tax bill from the IRA conversion.

There’s another reason it may make sense to convert now. Unlike traditional IRAs, Roth accounts offer no upfront tax break. But investments held in a Roth account are free of taxes when you withdraw them during retirement--no matter how much they’ve gained in value over the years.

So the cheaper stocks are when you convert to a Roth IRA, the greater your potential tax-free upside--assuming you have time to wait for the market to turn around.

“If you think your stocks might bounce back, it makes some sense to convert while values are down,” said Philip J. Holthouse, partner at the Los Angeles tax law and accounting firm of Holthouse Carlin & Van Trigt.