The first six months of 2022 have so far taken investors along for quite the ride. Thanks to record-high inflation in the US, rising interest rates, and geopolitical conflicts, many investors may feel uncertain about where they stand with their portfolio and wonder: What should I do?
First and foremost, we help clients navigate turbulent markets to avoid the temptation to panic and keep executing the financial plan that has been specifically designed with their goals and considerations in mind. Then, we make lemonade out of lemons and focus on actions that can add value long-term. That typically includes tried-and-true strategies such as systematic and disciplined rebalancing when portfolios drift from their intended targets and tax-loss harvesting. Yet another strategy that can potentially maximize a portfolio nest egg is a Roth Conversion at what is considered “bargain” or discounted prices.
What is a Roth Conversion?
With a Roth Conversion, you elect to take a portion of your Traditional or pre-tax retirement assets and convert them to Roth or after-tax assets. You essentially elect to pay ordinary income tax today on that converted dollar amount. However, once the assets are converted to Roth assets, they will grow and accumulate tax-free, and any future distributions (assuming you meet age requirements and the 5-year rule) will be tax-free.
Generally, a Roth conversion makes sense if your marginal tax rate today is lower than it is expected to be when the funds are withdrawn in the future.
Example: Jane is 60 years old and just sold her business last year. She is now fully retired and has no wages or earned income though she is relying on dividends, interest, and capital gains generated by her taxable brokerage to support to lifestyle spending needs. She is currently in the 12% marginal tax bracket. She does not anticipate any other income until Age 70 when she will begin taking Social Security. Then at age 72, she will be subject to sizeable Required Minimum Distributions. Her wealth advisor projects that she will then jump into the 24% marginal tax bracket at age 72 when her RMDs begin along with her Social Security. As a result, her financial advisor councils her to convert assets today at the 12% marginal rate as opposed to realizing them at the 24% marginal rate.
An added benefit of a Roth Conversion is that anyone can elect to convert pre-tax assets to after-tax Roth accounts. Conversely, many investors find that they are unable to make contributions to a Roth IRA account due to the income limitations imposed by the IRS. Conversions provide more opportunities for investors to accumulate more assets (and future growth) in after-tax accounts.
Why does it make sense to do now?
When capital markets are in a temporary decline, you can convert assets at discounted values (i.e. more shares at a lower price). This enables you to convert a higher percentage of your pre-tax account assets. Here is an example to illustrate:
Example: In 2022, Jane determines that she would like to convert $20,000 from her Traditional IRA to a Roth IRA. On January 1, 2022, Jane holds 1,000 shares of Fund ABC (trading at $100/share) in her Traditional IRA. If she converts $20,000 on January 1, that equates to 200 shares of Fund ABC ($20,000 Total Conversion Budget/ $100 share price). As a result, 20% of her Fund ABC shares in her Traditional IRA would be converted to her Roth IRA.
Now, let’s assume that instead of converting on January 1st, she converted on June 1st when Fund ABC was trading at $80/share. If she converts $20,000 on June 1st, that equates to 250 shares of Fund ABC ($20,000 Total Conversion Budget/ $80 share price). As a result, 25% of her Fund ABC shares in her Traditional IRA would be converted to her Roth IRA.
Ultimately, the key point is that a market downturn presents an opportunity to convert a higher percentage of a pre-tax account to a Roth account for the same amount of taxable income. Then, when the temporarily depressed market eventually rebounds, a larger percentage of the future growth occurs in the Roth accounts. This results in a few additional added benefits: 1) Unlike traditional pre-tax retirement accounts, Roth account owners are never subject to Required Minimum Distributions that will generate taxable income, and 2) The tax-free treatment of Roth distributions also continues to those that are designated to inherit your Roth account, making this a particularly effective asset to leave behind for future generations.
What are pitfalls to be aware of?
Although Roth Conversions can be a great strategy to take advantage of in a down market, they are not the right solution for everyone. For starters, they may not be the most tax-efficient decision- particularly for those that currently find themselves in high tax brackets. There is little sense in converting assets at high rates today if you could defer and pay at potentially lower rates in the future.
Additionally, consider if you have sufficient cash on hand through checking and/or savings accounts to pay the tax due on the conversion. If you instead use part of the converted assets to pay the tax, you leave less assets available in the tax-free Roth account to enjoy a market rebound. This diminishes the impact of the Roth Conversion over the long-term.
Lastly, it is also important to note that once a Roth conversion is executed, it cannot be undone. Since conversions rely on income projections that can vary greatly from year to year, you should work closely with your wealth or tax advisor to avoid accidentally converting a dollar amount that will push you into a higher tax bracket.
If you believe you have an opportunity to take advantage of this planning strategy, having a knowledgeable Wealth Advisor to guide you is essential. At ML&R, we take a disciplined approach by focusing on the things we can control rather than trying to chase returns in a market that is unpredictable. Roth conversions are just one of many planning considerations we take into account for clients!
Please feel free to reach out for a consultation if you would like to learn more.