Properly Utilizing the Roth Conversion
Although negative years in the market are not comfortable for anyone, we are sure by now you have heard many people say that years like the one we are having in 2022 also present some of the best financial opportunities. But that goes beyond just “buying low”, as there are financial strategies that sometimes make even more sense to do when the market is down. One of those that we want to focus on here is Roth Conversions.
Roth IRAs provide a vehicle for tax-deferred growth, and the biggest appeal of them is that the money can ultimately be withdrawn tax-free as long as the owner is 59 ½ years of age and it has been at least 5 years since the first contribution was made to the Roth IRA. The prospect of many years of tax-free growth is extremely appealing, especially the younger you are because there is an opportunity for decades of compounding. But one of the biggest limitations of Roth IRAs is that individuals are restricted to the annual contribution limit, which in 2022 is $6,000 plus an annual $1,000 “catch-up” contribution for those 50 years or older. However, there is one other way to build up the balance in your Roth account, and that is by converting money from a pre-tax (e.g. traditional IRA or 401(k) plan) retirement account to a Roth account. A person can convert any amount of their pre-tax account by reporting the conversion as ordinary income and paying the taxes on that amount in the year it is converted.
Having the option to make a Roth conversion is good for tax planning purposes if used effectively, but it does not mean that doing so is always most tax-efficient decision. If the amount converted bumps an individual into a higher tax bracket than the one they will be in when they withdraw the money, then all else being equal it will actually have lost that person money after all taxes are paid. Often times the best strategy is to build up pre-tax IRA accounts during high income working years, and then utilize Roth conversions once retired when income is low before Required Minimum Distributions kick in. But it all comes down to an individual’s current and expected future tax rates, as well as the expectations for how the government will change tax rates.
For investors who were already thinking about making a Roth conversion, a bear market essentially puts the conversion “on sale” at temporarily lower prices. So, when the IRA value is temporarily low in a bear market, it allows the individual to convert a larger portion of their IRA (potentially without pushing themselves into a higher tax bracket), and then once it is in the Roth if the market rebounds to its previous levels, all of that gain would be free of tax.
Since the Roth conversion will create a new tax liability, the benefits of doing a Roth conversion “on sale” will also depend a lot on how that individual sources the funds to pay the tax burden that year. Many times people will withhold money from their conversion to pay some of the taxes directly from their IRA, but this is actually the least efficient place to take from. A better source to pay the taxes from would be cash on hand, if it is possible. That would allow the most possible money to be converted to the Roth to enjoy a market rebound that the cash on hand used to pay the taxes would never have benefited from anyway. The same can be said of a taxable investment account. It would be less preferred than using cash on hand, since that would involve selling part of your portfolio while the market is low. But it’s still a better option than paying the taxes from an IRA, since all of the gain in a market rebound of a taxable account would be subject to taxes.
In the end, there are many factors that go into properly utilizing a Roth conversion for efficient tax planning. Many investors who are currently in high tax brackets would still be better off not doing conversions, and instead making tax deductible IRA contributions, even when the market is down. No two people’s situation are the same, so please consult your financial advisors to evaluate whether a Roth conversion makes sense for you or not.
By Matt Muench CFP® – Wealth Manager at Bassett, Dawson, and Foy