The year 2022 was challenging with the U.S. stock market posting a -19% return and the U.S. bond market not far behind at -13%. However, enough time has passed to where it is beneficial to conduct an after-action review. This isn’t an examination of what the ideal investment would have been because that information was unknowable at the time and trying to time the market is a fool’s errand.
Instead, we need to examine what opportunities to take advantage of during a down market. One such opportunity can be a Roth conversion.
A Roth conversion transfers funds from your tax-deferred traditional IRA account to your tax-exempt Roth IRA. Both accounts are considered tax advantaged, meaning they are granted special privileges by the government to encourage retirement saving, but they function in different ways.
Traditional IRAs and traditional 401(k)s are the most common retirement accounts and incentivize saving with their tax-deferred status, meaning money you contribute to these accounts reduces your taxable income for the year the contributions are made. The caveat is that the government eventually wants the IRA account spent down so it can collect on the income taxes you deferred paying and the government deferred on receiving. This is why required minimum distributions (RMDs) kick-in for IRAs at age 73. You are required to take a minimum amount out of the IRA, though you can still take out more than the RMD. These distributions are taxed as ordinary income.
Roth accounts operate a little differently. A Roth IRA or Roth 401(k) allows you to make after-tax contributions that then grow tax-free, meaning future withdrawals from the account are not taxed.
With that explanation out of the way, let’s go back to 2022. Let’s say a mutual fund in someone’s Traditional IRA is worth $100 per share at the start of 2022. Then toward the end of the year that same mutual fund is down 20% and worth $80 per share.
If someone wanted to do a Roth conversion for $20,000, they could move 250 shares of that mutual fund from their tax deferred IRA to their tax-exempt Roth. This is compared to the 200 shares they could move for $20,000 at the start of 2022. The market downturn is a temporary discount that allows us to move more shares for the same dollar amount. The Roth conversion is still taxed as ordinary income in 2022 but it may lead to a more tax efficient portfolio depending on the investor’s situation. What are the situations where it pays to pay taxes now instead of later?
Scenarios in which a Roth conversion would be beneficial share one commonality, the expectation that future taxable income will be higher than current taxable income. This can even extend beyond someone’s lifetime into the realm of estate planning.
An example within your lifetime is if you are already retired with a stable source of income but have a sizable IRA or 401(k) account balance and are concerned that future RMDs will force you into a higher tax bracket. If you do not want to be pushed into a higher tax bracket in the future, it might make sense to maximize your current tax bracket by conducting a Roth conversion. This will draw down your tax-deferred IRA account balance and reduce your RMD in the future.
If you are interested in estate planning and care about the tax impact on your beneficiaries, then Roth accounts are great to inherit since the beneficiary must withdrawal all proceeds within 10 years of inheriting the account and those proceeds are tax free. This might be preferable to an IRA whose proceeds must also be taken within 10 years of inheritance but are taxed to the beneficiary as ordinary income. Let’s say instead of accounts going directly to a family member they are placed in a trust. If an IRA account is used, the trust will be required to take distributions which can then be taxed at a marginal tax rate of 37% if they exceed $14,450. The Roth has no such problem if placed in a trust since its proceeds are distributed tax-free.
Market downturns are frustrating and I’m happy that 2023 has been kind to investors, but the best time to examine your investment and planning strategy is when times are good. One opportunity, among many, is a Roth conversion, and it just so happens its greatest benefit is achieved when investors post negative returns.
Nicholas Haberling is a partnership advisor at Community First Bank & HFG Trust in Kennewick.
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