Recession Tax Planning: Take advantage of a declining market by saving on taxes

The market experienced a crazy summer. We saw the market plummet at record rates, followed by continuous volatility caused by further market declines, an inverted yield curve, and ongoing trade war discussions. Talks of recession started during the summer and will continue into the fall. I cannot speak to when the recession will come, but I can speak to what actions to take when we experience an economic recession.

For those panicking about the decline in the markets, I have a positive spin on the potential economic downturn. During a recession, taxpayers should take advantage of a declining market by saving on taxes by converting retirement savings accounts.

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Recession Tax Planning: Roth IRA Conversion

As stated, taxpayers can save on taxes by converting a traditional individual retirement arrangement (IRA) to a Roth IRA. The retirement savings account conversion allows market participants to take advantage of a declining market. By taking advantage of the economic recession, you should save money in the long run on taxes. Let's see how it works!

A quick guide for those confused about the terminology:

The IRS defines an IRA as a tax-favored personal savings arrangement, which allows you to set aside money for retirement. There are several different types of IRAs, including traditional IRAs and Roth IRAs (Must know tax rules relating to your IRA).

Traditional IRAs create current tax benefits.The contributions to a traditional IRA decrease taxable income, essentially creating a pre-tax contribution to the IRA. When money is taken out of the traditional IRA, the principal amounts and earnings are fully taxable.

Roth IRAs create future tax benefits. The contributions to a Roth IRA are after-tax contributions, meaning the contributions are not tax deductible. However, when the money is taken out from the Roth IRA, the principal amounts and earnings are tax-free.

The IRS allows taxpayers to convert traditional IRAs into Roth IRAs.

When to convert your traditional IRA to a Roth IRA?

The following discussion is merely a tax planning suggestion. You should not feel inclined to convert your traditional IRA into a Roth IRA. The conversion is a permanent act, which requires much thought and discussion with your tax adviser. 

If you choose to follow the IRA conversion tax strategy, the optimal time to convert your traditional IRA into a Roth IRA is when the valuations of your retirement accounts are low. Retirement savings accounts will have lower valuations during market declines, making an economic recession an optimal time to convert to a Roth IRA.

The IRA conversion strategy creates a tax savings advantage because when you convert from the traditional to the Roth, you pay income taxes on the value ($ amount) converted. The tax amount is based on the current value of the savings amount converted. For example, say we have a stock portfolio in our traditional IRA. The stock portfolio holds 100 shares valued at $10 each ($1,000). We plan to follow the IRA conversion strategy during the economic downturn. As predicted, the economy falls into a recession, causing our portfolio stock value to decline to $5 per share ($500).

So, we convert a portion of the traditional IRA into a Roth IRA. For simplicity, we convert the stock portfolio discussed above. The stock portfolio had a total valuation of $1,000, but it now has a valuation of $500 after the market declines. When we convert, we pay tax on the $500 amount. We are able to convert all 100 shares from a traditional IRA into a Roth IRA by making the conversion election and paying tax on its current value. Now, the stock portfolio value in the Roth IRA should increase in value when the market increases, resulting in tax-free growth and future tax-free withdrawals. 

In simple terms, when the investments in your traditional IRA decline in value, you can transfer a greater portion (amount of shares) to a Roth IRA for a lesser taxable income amount. The transferred investments will experience tax-free growth and tax-free withdrawals upon retirement.

The conversion is permanent...

As I stated earlier, the conversion from the traditional IRA to the Roth IRA is permanent and cannot be reversed. The conversion strategy is not for everyone. Make sure you have money available to pay taxes on any amount converted. Also, make sure you have sufficient time to allow for the market increases, and thus, allow time for the tax-free growth!

Please consult with a tax adviser when considering converting from a traditional to a Roth IRA. The conversion rules are complex and require expertise.

In conclusion

Do not panic about an economic recession. Instead, have a positive outlook on the situation by following the conversion strategy and saving on future taxes. Take advantage of the declining market by transferring investments with lower values from a traditional IRA to a Roth IRA. You will pay less tax on a greater number of converted investments. The result is tax-free growth and tax-free withdrawals. 

Please comment below or email me [textbooktax@gmail.com] for any and all questions and concerns about the IRA conversion tax planning strategy. As always, please share with friends and family or on social media to educate others on how to take advantage of a declining market by saving on future taxes!

Disclaimer

Textbook Tax does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers before engaging in any transaction.