Like many of my readers, I do my investing solely inside my IRAs. The recent market downturn got me to thinking if there's anything I can do to achieve some benefit from the drop in my IRA's value. One possibility is to cash out an IRA in its entirety in order to get a tax deduction for IRA losses, but that move requires cashing out my IRA which I'd rather not do, especially considering there's a 10% surtax for cashing out an IRA early. A more interesting tactic: I could convert some (or all) of my tax-deferred IRA funds into a tax-prepaid Roth IRA. Similarly, people can convert some or all of their tax-deferred 401(k) funds into Roth 401(k). By converting to a Roth when the the underlying investment is priced lower, there would be a lower tax upon conversion.
Here's an example. Let's say I have a traditional IRA that was worth $5,000. But now the account has declined in value to $4,000. I was thinking of converting half the funds into a Roth, which would have produced a tax impact of 2,500 multiplied by whatever my marginal tax rate for 2011 is. For someone in the 35% tax bracket, this move could cost $875. But now that the IRA value has dropped, converting half the fund now would only cost 2,000 times the marginal tax rate; or $700 at the 35% top rate.
Now converting to a Roth doesn't always make sense. In particular, market losses inside a Roth don't produce tax-deductible losses (which is the flip-side of the tax-free treatment for gains inside a Roth). And converting to a Roth still requires a prepayment of tax now, which may or may not be desirable. However I do think this is one way to take some advantage of market losses inside an tax-deferred account.