Kyle Rolek, Retirement Planning Specialist
While Markets are Down, Should I Evaluate a Roth Conversion?
Updated: Feb 2
One positive during bad market time periods, like this year so far, is that market declines can provide a good opportunity to evaluate Roth conversions.
What is a Roth Conversion?
A "Roth Conversion" is transferring money from a pre-tax retirement account such as a Traditional IRA into a Roth retirement account such as a Roth IRA.
Why Evaluate a Roth Conversion?
1 - Pay tax now at current rates instead of paying tax later at potentially higher future rates. (tax rates for most taxpayers are scheduled to increase in 2026 when 2017 tax cuts expire)
2 - Avoid tax on future investment gains.
3 - Reduce or avoid future Required Minimum Distributions.
Jane's Roth Conversion
Jane has $100,000 in her Traditional IRA and $0 in her Roth IRA.
Jane decides to convert $20,000 from her Traditional IRA into her Roth IRA. To do this, Jane transfers $20,000 from her Traditional IRA to her Roth IRA.
Jane now has $80,000 in her Traditional IRA and $20,000 in her Roth IRA.
The $20,000 Jane converts from her Traditional IRA to her Roth IRA is included in her taxable income this year.
However, because this $20,000 went into her Roth IRA, she won't have to pay taxes again in the future when she takes this money out of her Roth IRA (at least under current tax law).
Further, Jane also won't have to pay tax on any future earnings made by this $20,000 now that it's in her Roth IRA. If this $20,000 was left in her Traditional IRA, on the other hand, future earnings would have been taxed when distributed.
Why Would Jane Evaluate A Roth Conversion While Markets Are Down?
Because taxable income generated by a Roth conversion is based on the market value of the shares at the time of conversion.
For example, let's say Jane has 1,000 shares of a high-quality US stock fund within her Traditional IRA that she intends to hold for the long-term as part of her overall plan. Roth conversions make sense for her based on her unique situation, the main question is timing.
On January 1st, these 1,000 shares were worth $25,000. Due to year-to-date market declines, on June 1st, the market value of Jane's same 1,0000 shares has declined to $20,000.
If Jane waits to perform the Roth conversion until the market value recovers to $25,000, she'll have $25,000 of taxable income from converting the 1,000 shares.
On the other hand, if Jane performs the Roth conversion now while markets are down, she'll have $20,000 of taxable income from converting the 1,000 shares from her Traditional IRA to Roth IRA.
In this example, Jane will save $5,000 in taxable income from converting the 1,000 shares now while the market value is $20,000 compared to waiting until the market value recovers to $25,000.
Further, because the bulk of the eventual market and share price recovery will occur within her Roth IRA, the gains earned during the period of recovery plus all future gains are tax-free.
To be clear, Jane isn't selling or changing anything about her investments. She's transferring the exact same 1,000 shares from her Traditional IRA to her Roth IRA to perform the Roth conversion. This update is solely for long-term tax planning benefits and doesn't change her investment plan at all.
You may be thinking "well wouldn't Jane be even better off if she waited until her 1,000 shares decreased in value to $15,000 to perform the conversion?". Yes, in theory it would be best tax wise if she performed the Roth conversion at the exact bottom, but she won't know when that will be.
It could be a good strategy for Jane to convert at least some of what she intends to convert for the year now while markets are down. If prices continue declining, she can always decide to be more aggressive with her Roth conversion strategy and convert more again later in the year. She can perform multiple Roth conversions in one year if she chooses.
One positive during bad market time periods like this year so far is that market declines can provide a good opportunity to perform Roth conversions.
As illustrated above, Roth conversions are cheaper tax-wise in times when market prices are down.
Lower market value of shares = less taxable income triggered by Roth conversion = less tax!
Roth Conversion Tax Considerations
Roth conversions are most beneficial if your tax rate now is close to or lower than your tax rate in the future.
In some cases, if income now is significantly higher than it will be in the future, Roth conversions may not make sense yet (see third example below).
In other cases, if income now is anywhere close to income in the future, Roth conversions may make good sense due to the risk of potential future tax increases. This includes the scheduled sunsetting of the 2017 tax cuts in 2026 (although this could change between now and then, the tax rate for all brackets above 10% are scheduled to increase in 2026).
In the first example, Jane's taxable income is projected to be $10,000 this tax year. She left her job early in the year, received no severance, and doesn't plan to return back to work for the remainder of the year. This is an ideal scenario for Jane to do a Roth conversion.
Any Roth conversion amount will increase her taxable income this year. If her taxable income from other sources is projected to be $10,000 for the year, she can convert up to $10,550 from her Traditional IRA to her Roth IRA this year and be taxed at 10% on this amount (See tax table above. Assumes Jane is married filing jointly).
She may decide to be more aggressive with her Roth conversions this year to really take advantage of the low income year and convert up to the top of the 12% bracket. She could convert up to $73,550 while staying within the 12% marginal tax bracket (see tax table above).
In the second example, Jane's taxable income is projected to be $120,000 this year. She could convert up to $58,150 while staying within the 22% tax bracket (see tax table).
In this second example, if even her taxable income is projected to decline to $85,000 in retirement with social security, pension, and IRA distributions considered, Roth conversions could still be good for Jane to evaluate now. Even though her income will drop in retirement, her tax bracket is projected to be about the same based on current brackets (see tax table). In reality, her tax bracket may actually increase in retirement even though her income dropped if tax brackets go up across the board.
In the third example, Jane's taxable income is projected to be $400,000 this year. When she retires next year, her taxable income is projected to decline to $60,000.
In this third example, if Jane performed a Roth conversion this year, she'd be taxed at least at 32% and potentially higher depending on how much she converts.
If she waits until retirement when her taxable income is projected to decline significantly, she can perform a Roth conversion at tax rates as low as 12% based on current brackets. In this example, with such a large gap in income between the current year and the near future, it's probably best for Jane to wait until she retires next year to begin conversions.
Who Is Eligible to Perform a Roth Conversion?
Anyone with a balance in a pre-tax retirement account, such a Traditional IRA, 401k, 403b, or pension lump sum, is eligible to perform a Roth conversion.
Roth conversions don't always make sense though. As stated above, Roth conversions are most beneficial now if your tax rate now is close to or lower than your tax rate in the future.
There are other considerations with Roth conversion timing related to Medicare penalties and future Required Minimum Distributions not covered in this article. This article has some additional detail: Required Minimum Distributions
Evaluate Roth conversions with the help of your retirement advisor to determine suitability for your specific overall financial situation and long-term planning objectives.
Want To Discuss This Individually?
1 - For clients: Call or email me any time as always.
2 - For non-clients: Complete the form on the website to request a retirement planning consultation: www.rolekretirement.com
This is article is for informational purposes only and should not be considered as tax or legal advice. Advice is only provided after entering into an Advisory Agreement with the Advisor. See other disclosure here: Disclosures