Did you know that during the COVID-19 market crash in 2020, a $10,000 investment could have fallen to around $6,900 at the market's lowest point? Sounds bad, right? It was. People lost jobs, markets plunged, and nobody knew what would happen next.
But amidst all this, there was a silver lining for some investors.
Those who were considering converting their traditional retirement accounts into a Roth Individual Retirement Account (IRA) had a window of an opportunity. They were able to do so while account values were temporarily lower, which brought them a smaller tax bill on the conversion.
A Roth conversion in a down market can be a good idea for several reasons. Let's understand why.
What is a Roth conversion?
A Roth conversion is the process of moving money from a traditional retirement account, such as a Traditional IRA or 401(k), into a Roth IRA. When you convert funds, you pay taxes on the amount converted in the year you make the conversion. But the upside is that all your future qualified withdrawals from the Roth IRA are then tax-free.
There are several reasons why investors choose a Roth conversion. The ability to enjoy tax-free withdrawals in retirement is, of course, the most evident one. In retirement, you have limited income sources, and if you have to pay tax on those, you will likely be left with very little. A Roth conversion helps you pay taxes now so you can enjoy tax-free withdrawals later. The conversion can also help higher-income earners access Roth IRA benefits, even when their income exceeds the limits for direct Roth IRA contributions. Roth IRAs have income caps that limit some people's ability to contribute. However, you can make non-deductible contributions to a Traditional IRA and then convert those funds to a Roth IRA.
Is a Roth conversion worth it?
It can be worth it because it may provide tax relief in retirement. On top of that, it also allows future investment growth to occur in a tax-free account. However, there is a downside to the conversion. You have to pay tax on the transferred money when you move it. Traditional retirement accounts generally contain pre-tax money. So, when you make the conversion, the tax bill comes knocking immediately. The more money you have in your retirement account, the more taxes you may owe on the conversion.
This makes a Roth conversion a critical financial decision. You need to carefully weigh the potential long-term tax benefits against the taxes you will incur right now before deciding whether it is the right move for your situation. In fact, it may be advisable to discuss your Roth conversion tax strategy with a financial advisor at length before taking any action.
Roth conversion in a down market
Moving on to the next question, when should you do a Roth conversion? There are several situations where a Roth conversion can be the right choice. You may consider one during a low-income year, in the period between retirement and claiming Social Security benefits, before Required Minimum Distributions (RMDs) begin, or when you expect your tax rate to be higher in the future. However, one of the most suitable opportunities for a Roth conversion is a market downturn.
As the saying goes, every cloud has a silver lining. A market decline may actually be one of the most tax-efficient times to move money from a traditional retirement account into a Roth account.
To understand why, it helps to first know how Roth accounts work.
Unlike traditional IRAs and traditional 401(k)s, Roth accounts do not provide an upfront tax deduction. Contributions are made with money that has already been taxed. In exchange, you receive tax-free withdrawals later. Once you reach age 59½ and have met the five-year holding requirement, qualified withdrawals from a Roth account can be taken completely tax-free.
And, the story does not end here. Not only do you avoid taxes on future growth, but you also gain protection against future tax law changes. Nobody knows what tax rates will look like in the future. The government could wake up tomorrow and feel they need to increase tax rates. Hence, there is no denying that having money in a Roth account can provide a source of tax-free income, regardless of what happens in the future. You do not have to worry about paying more tax later.
The catch, of course, is that a Roth conversion is taxable. When you convert money from a traditional IRA or traditional 401(k) to a Roth account, the amount converted is considered your ordinary income for that year. This money is then taxed at the income tax rate you qualify for, depending on your overall annual income.
But a market downturn can help you here. Let’s take an example:
Imagine you own a traditional IRA worth $100,000. If you convert the entire account to a Roth, you will generally owe taxes on the full $100,000 conversion amount. On top of this, you will likely have other sources of income. Depending on your salary, business income, investment returns, and the conversion, you could end up paying a lot in taxes. Now imagine the market falls and your account value drops to $70,000. As unpleasant as this sounds, this can work in your favor. You now have the unique opportunity to convert a lower amount and pay less tax. If you convert the account while it is worth $70,000, you will owe taxes only on $70,000, rather than $100,000. So, even though you are converting the same investments, you will get a tax discount. Now suppose the market recovers over the next few years and the account grows back to $100,000, or even more. The growth will occur within the Roth account, and it can potentially be withdrawn tax-free in retirement. This Roth conversion tax strategy can be helpful if you have a long term horizon before retirement. Your investment would have enough time to recover and grow.
However, there are some things you should consider nevertheless. The next section covers those.
Things to consider when you opt for a Roth conversion in a down market
1. Make sure you can foot the tax bill
Irrespective of the market conditions, there is one important requirement for a Roth conversion. You need to have sufficient funds to pay the taxes. Ideally, you should not use your retirement funds to pay taxes, as this can reduce the amount invested in the account. This will ultimately impact your retirement savings. This is why, before moving forward, you should ensure you have sufficient funds to cover your tax liability.
2. Check if you are in a high tax bracket
Another factor to consider is your current income. If you are already in a high tax bracket, converting a large amount all at once could push you into an even higher bracket and increase the taxes you owe. Even with a market downturn and a relatively low account balance, you could still end up paying a lot in taxes. In such a case, you could choose to convert smaller amounts over the course of a few years instead of converting everything at once.
Luckily, there is no annual limit on Roth conversions. Unlike Roth contributions, which have income and contribution caps, Roth conversions can be done regardless of income level. You can convert as much or as little as you want, and you can perform multiple conversions over time. So, rather than converting your entire account in one year, you can take advantage of multiple market downturns. You can also use lower-income years to make the conversion. Or look for other favorable tax situations. Converting your retirement account bit by bit allows you to fit into lower tax brackets each year and manage the tax impact more effectively.
3. Understand the permanence of your decision
A Roth conversion is not a decision you should make lightly. Once you complete a Roth conversion, you cannot undo it. Earlier investors had the option to recharacterize a Roth conversion and reverse the transaction. This allowed people to move the money back into a traditional IRA. That option is no longer available.
At present, once the conversion is completed, you cannot undo it. The taxes associated with the conversion will still be owed, even if the value of the investments declines afterward. So, before converting, make sure you are comfortable with the tax consequences.
4. Know the rules before you convert
The Roth conversion tax strategy comes with rules that you need to understand. The first rule is the five-year rule for converted funds. Each Roth conversion has its own five-year waiting period. If you withdraw converted amounts before five years have passed, you could face taxes and a 10% penalty. Hence, a Roth conversion is usually best suited for money that you do not expect to need in the near future. If there is a chance you will need access to those funds within the next few years, a conversion may not be the right move.
5. Speak to a financial advisor in depth
A Roth conversion can affect you in several ways. It impacts your tax situation, future retirement financial security, present budget, and more. This is why it is important to discuss it in depth with a financial advisor.
A financial advisor can help you evaluate the full picture, including federal taxes, state taxes, retirement income needs, and even healthcare-related costs. For example, the amount you convert is added to your taxable income for the year. A high account value will push you into a higher tax bracket, increase your state tax liability, or affect eligibility for certain tax credits and deductions. An advisor can help determine how much money you should convert in a year.
Advisors can also help you factor in Medicare. Your Medicare premiums are partly based on your income. If a Roth conversion increases your taxable income, you could end up paying higher Medicare premiums in future years. Financial advisors can also help coordinate Roth conversions with other retirement income sources, such as Social Security benefits and pension income, to create a more tax-efficient retirement strategy overall.
Roth conversion in a down market – Does it make sense after all?
Yes, it does. Converting assets during a market downturn may allow you to pay taxes on a lower account value, which can reduce the tax you pay on the conversion. If the market recovers afterward, the future growth inside the Roth IRA will be tax-free.
However, you should not look at a Roth conversion in isolation. Several factors need to be considered, such as your current income, tax bracket, expected future tax rate, and the amount of tax you may owe on the conversion. You should also think about whether you may need access to the money in the near future.
A Roth conversion is not the right choice for everyone. So, consider discussing the strategy with a financial advisor. You may use our financial advisor directory to find vetted professionals who can guide you on whether you should opt for a Roth conversion.
Frequently Asked Questions (FAQs) about the Roth conversion tax strategy
1. Is a Roth conversion worth it?
Yes, a Roth conversion can be worth it as it helps you lower your tax bill in retirement when you make qualified withdrawals. Having said that, it does come with immediate tax consequences. To know if it is the right choice for you, you need to evaluate the following factors:
- Have you discussed the decision with a financial advisor yet? It is important to speak to a financial advisor to understand the pros and cons of the conversion.
- Are you in a higher tax bracket? This will result in a high tax bill even if you convert the funds during a market downturn.
- Do you need the money immediately? Roth conversions are subject to a five-year rule. If you withdraw converted funds within five years of the conversion and you are under age 59½, you may face a 10% early withdrawal penalty on the taxable portion of the conversion. Once you reach age 59½, the 10% penalty no longer applies.
2. Can I do a Roth conversion during a market high?
You can convert to a Roth IRA anytime, even when the market is high. However, the value of your investments may be high, and you may pay more in taxes. This is why it is advised to do it when the market is down or during a low-income year, when your other taxes may be low.
3. Can you reverse a Roth conversion?
No, you cannot reverse or recharacterize a Roth conversion. All conversions made on or after January 1, 2018, are non-reversible.
For additional information on retirement planning strategies that can be tailored to your specific financial needs and goals, visit Dash Investments or email me directly at dash@dashinvestments.com.
About Dash Investments
Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.
Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.
CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.