Market declines are painful. When they happen (as they are in 2022), you’ll often see recommendations to take advantage of the decline (e.g., tax-loss harvesting). Most of these recommendations are value-adding, however, we often see one with which we disagree: to do a Roth conversion after a market decline.
To make our view on this clear: we do not recommend converting your traditional IRA money to Roth IRA money (i.e., doing a ‘Roth conversion’) solely because markets have declined.
To understand why, let’s first consider the reasoning often used to justify the recommendation to convert in a market decline. It goes like this: when markets decline, your IRA balance is lower today than it was before the market fell; therefore if you convert today, you will pay less in tax dollars than if you converted before the market fell. This is true, but it does not justify a conversion. The focus of a conversion should be on tax rates not dollars paid. If dollars paid were the reason to convert, the following conclusion would be reached:
- If the goal is to minimize the tax dollars paid on conversion, then you should convert today if you think your IRA balance might ever be higher
- Therefore, since you will obviously assume your IRA balance will grow in the future, you should convert all your IRA money today and never hold traditional IRA money (even if the market didn’t decline!)
To be clear, again, we don’t recommend doing this.
In fact, where the market has been in the past has no bearing on the Roth conversion decision. Instead, the primary driver of this decision is a comparison of your current and future tax rates. Paying less taxes today when the market declines will still be worse economically if your tax rate today is higher than the future. To help illustrate why, let’s first back up and review the tax benefits of IRA accounts and how those relate to Roth conversions.
There are two types of Individual Retirement Accounts (or IRAs): Traditional IRAs (which consist of pre-tax money) and Roth IRAs (which consist of after-tax money). When you contribute to a Traditional IRA, you receive a tax deduction and the account grows tax-deferred. When you eventually take a withdrawal, you’ll owe taxes based on your marginal tax rate in the year of withdrawal. A Roth IRA works in the opposite way. There’s no tax deduction when you contribute, but the account growth and withdrawals are tax free.
If you’re in a higher tax bracket today compared to your estimated tax rate in the future when you plan to make withdrawals, it makes sense to contribute to a Traditional IRA (assuming you’re eligible). For example, if you’re in the 32% tax bracket today and estimated to be in the 22% bracket in the future, you’ll save 10 cents on every dollar you contribute. In other words, for every $1 you contribute today you’ll avoid 32 cents in taxes and then pay 22 cents in taxes when you make a withdrawal – that’s a net 10 percent savings!
If you’re in a lower tax bracket today than you would be in the future, a Roth makes sense. For example, if your marginal tax rate is 22% today but will be 32% in the future, you’d be better off making a Roth contribution (forgo a deduction worth 22 cents for every $1 you contribute) while avoiding taxes in the future (32 cents). Again, you’ll save a net 10 percent if you do this correctly.
For most wage earners near the middle or end of their career, their tax rate will likely be higher while they’re working than when they retire and have lower income.
Now, let’s pivot to Roth conversions, which is transferring funds from your Traditional IRA to your Roth IRA and paying the taxes today to avoid them in the future. The same tax rate logic applies to the decision about whether to do a conversion. If you go back to my example in the previous paragraphs, paying taxes today makes sense when you are in a lower tax bracket than you expect to be in the future. If you’re in a higher tax bracket today than in the future, your savings becomes a loss. Finally, if you’re in the same tax bracket, you’d be indifferent.
As I also said, people are generally in higher tax brackets while they are working. So, converting tends to be a great strategy when you stop working and before you start taking Social Security. For example, if you’ve retired at age 60 and Social Security benefits won’t start until age 67 or 70, then you can likely convert at very low rates!
Throughout this explanation, notice that I haven’t said anything about where the market has been and whether your balance is higher or lower than it used to be. Again, that doesn’t impact this decision. Michael Kitces, an advisor to advisors, has written about this concept here:
There are only four factors that impact the wealth outcome when choosing between a Roth or traditional IRA (or other retirement account). They are: current vs future tax rates, the impact of required minimum distributions, the opportunity to avoid using up the contribution limit with an embedded tax liability, and the impact of state (but not Federal) estate taxes… By far, the most dominating factor in determining whether a Roth or traditional retirement account is better is a comparison of current versus future tax rates… The principle of this equation is remarkably straightforward – the greatest wealth is created by paying taxes when the rates are lowest.
Again, to put it simply, you should not do a Roth conversion just because your IRA balance is lower today than it was at some point in the past (all other things unchanged). In fact, if you weren’t planning on doing a Roth conversion before the market declined, doing a Roth conversion because markets have declined can actually cause permanent financial loss.
That final point is worth emphasizing. Investors can make an IRA conversion even worse if the amount they convert pushes them into a higher tax bracket. If, for example, you do a Roth conversion this year because markets are down, but that conversion pushes your tax rate up when your tax rate today is already higher than what you expect in the future, then you’ve paid an additional tax you never needed to pay. We’re pretty sure no one wants that outcome!
In summary, here’s what you should keep in mind when you hear about Roth conversions:
- Don’t do a Roth conversion just because markets have declined
- Converting too much may needlessly push you into a higher tax bracket and result in economic loss
- They are tricky since they require building a financial plan that estimates your tax rate today versus your tax rate in the future
- They are a valuable tax strategy when it makes sense to do them
- You’ll likely have an opportunity to do them at some point so be patient and make sure you’ve evaluated your current and projected tax situation beforehand
As always, please reach out if you’d like to discuss.
Disclosures:
