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7 Considerations for Doing Roth Conversions in a Down Stock Market

Retirement Planning

Introduction 

One of the accepted facts in the world of investments is this:  When the stock market goes down, Roth conversions start looking more attractive to investors.  Since the coronavirus ended a decade-plus bull market earlier this year, that point seems to be more amplified.  This article aims to help explain the benefits of doing a Roth conversion in a down market, as well as outline 7 things you should consider when doing so, especially for the first time. 

Benefits of Roth Conversions in a Down Stock Market 

Let’s assume that you’ve made the decision to start doing Roth conversions (debating whether to Roth or not to Roth is beyond the scope of this article).  Usually, people have a certain dollar amount in mind.  This makes sense, because you can estimate the taxes you’ll pay on that conversion.   

In other words, the argument is that when the stock market declines, you can convert more shares (of any investment) at the fixed dollar amount you’re paying taxes on.  Then, when the stock market eventually recovers, all of that appreciation grows tax-free.  The numbers work.  The math works.  But it’s not as simple as that. 

In fact, here are seven things you should consider if you’re looking to do a Roth conversion in a down market. 

Roth Conversion Consideration #1:   This should be a part of your overall Roth conversion strategy, not just a one-off decision. 

If this is an idea that just came into your head when the stock market started declining, you might want to take a step back and think about how this fits in the bigger picture.  For example, if you’re in the 37% tax bracket (the highest tax bracket), it probably doesn’t make sense to do any Roth conversions if you’re going to be in a lower tax bracket in the future.  Or, perhaps it does.  The fact is, you don’t really know if this conversion is a one-off idea that you’re trying to sandwich in between a variety of other tasks. 

Odds are, if you’ve accumulated a significant amount in your retirement accounts, then converting everything in one year will wreak havoc on your tax bill.  Your tax planning deserves a more focused effort than this.  Build a Roth conversion strategy, use it to develop a multi-year plan, and then incorporate this year’s opportunity into that plan. 

Roth Conversion Consideration #2:  Asset location is key. 

Once you decide how much you’d like to convert, then you’ll want to be mindful of asset location.  You might have heard of asset allocation, which is when you decide what to invest in (stocks, bonds, cash, etc.).   

Asset location is a little different.  You can think of it as a tax-focused ‘next-step.’  Asset location recognizes the tax treatment of different investments, and identifies the type of account that best complements that tax treatment.   

While we look at the types of accounts and the investments that might go into them, please understand this is a very big-picture view—not intended as specific investment advice. 

Traditional IRA:   Since this is a tax-deferred account, it’s a good place for items that would result in ordinary income today.  For example, CDs or corporate bonds generate interest income, which is taxed at higher rates than capital gains.  If you had a choice between putting them in a taxable account or a traditional IRA, you would want to choose the latter. 

Roth IRA:  Roth IRAs are great for investments which are expected to achieve out-sized returns over time.  Think aggressive stocks you expect to outperform the market.  Your overachievers should be in your Roth IRA. 

Taxable accounts:  You don’t want to pay taxes on anything at all.  But you’re likely going to have to put something into a taxable account.  You might consider tax-free investments, like municipal bonds.  You also might look at dividend-paying stocks, because qualified dividends are taxed at preferred tax rates (which can be as low as 0% if you’re in the lowest tax brackets). 

Again, this is painting with a broad brush, but the point is this:  after your Roth conversion, you’ll want to make sure that your asset location is appropriate.   Your financial advisor should help you with this, particularly since they should be helping you avoid any mistakes along the way (see #5 below). 

Roth Conversion Consideration #3:  Don’t get too fancy with the execution.  Stay with the plan. 

You built a plan, whatever it is.   Perhaps you decided to do some Roth conversions now, then take a look later in the year when you discuss taxes with your accountant.  Perhaps you’re going to do everything now.  Perhaps you’re going to wait until you talk with your financial advisor.   

But unless something significantly changes, don’t get too cute.  And definitely don’t get off track by watching the markets. 

Roth Conversion Consideration #4:  Don’t let market timing throw you off course. 

What is market timing?  It’s simply trying to figure out what the market is going to look like (near-term), then placing your bets accordingly.   

Long-term, the market is a little more simple—it’s going to go up as long as humans keep creating value, inventing things, and building stuff.  And if you don’t believe that, then you might consider selling everything now and stocking up on bullets, bullion, and land with high ground to build on. 

But trying to see where the stock market is going to be in a month, six months, or even a year—that’s a fool’s errand.  And if you’re waiting to execute on your Roth conversion because you want to ‘get more bang for your buck,’ then you might be sorely disappointed. 

Roth Conversion Consideration #5:  Mistakes are costly.  Avoid them. 

Doing the math on a Roth conversion is straightforward.  Actually doing the Roth conversion involves a lot of mechanics that you might not have accounted for.  If you’re doing this yourself, you might be wondering: 

  • Does my online account allow me to transfer shares of my investments, or do I have to sell first, then transfer cash? 

  • Which investments do I transfer (or liquidate so I can transfer cash)? 

  • What paperwork is required to do this? 

  • Do I need to open a new account? 

And along the way, there are any number of simple mistakes that can cost you.  For example, a fat-finger error could turn your $10,000 Roth conversion into a $100,000 one.  That you pay taxes on.   

And thanks to the Tax Cuts and Jobs Act of 2018 (TCJA), Roth conversions cannot be recharacterized.  In plain English, a Roth conversion generally cannot be undone, especially if you were the one that pushed the ‘Confirm’ button.  You might ask your custodian, but you probably won’t get much help.  Your tax professional might outline the options you have—but they’re probably going to be limited options that will end up costing a lot of money in fees and tax work. 

The simplest way to avoid having to fix a mistake is to avoid it.   

Roth Conversion Consideration #6:  Be mindful if you have both deductible and non-deductible IRA accounts. 

The IRS states that if you have both deductible (pre-tax) and non-deductible IRAs, then you have to recognize a prorated amount of your conversion from each account.  If you have only a pre-tax IRA (which most people have), then you’re expecting to pay taxes on the full amount.   

Conversely, if you have only a non-deductible IRA, then you’ve already paid taxes and don’t have to pay taxes again.  This generally occurs for high-earners who also contribute to an employer-sponsored plan, which makes them ineligible for directly contributing to a Roth account, or deducting their IRA contribution on their tax return.  This is also known as a backdoor Roth conversion.   

If you have both accounts, you should understand that things can get tricky, and you might want to consider the tax consequences (and possible opportunities, based upon your situation).  We wrote a case study article based on one of our clients, which you can read here. 

Roth Conversion Consideration #7:  Keep track of ALL your taxable income 

Not keeping track of income can cause your tax bill to go off track in a huge way.  And the hardest thing is that retirement represents such a change in your cash flow that it’s hard to tell where your taxable income might come from.   

For example, let’s imagine that you’ve planned your retirement and know that you’re going to stop your W-2 income.  You’ve been planning for this for months, possibly even years.  You’ve got your monthly budget planned based on all the money you’re not going to spend—no more commuting costs, no more clothes that you have to buy for work, no more lunches at the office.  But then, you run into an emergency you didn’t expect.  No problem—sell some stocks, raise the money, and move on with the determination that you’ll do a better job next time.   

Or maybe you’re looking to do some tax-loss harvesting.  If you’ve accumulated your shares over many years (like in a employee stock plan), the recordkeeping alone could be very daunting. 

Well, depending on that stock sale, you could be facing no additional taxes when you file your return, or you could be facing a huge tax bill.   

The thing is, unless you keep track of all of your taxable income, you just don’t know.  Then, when you (and your spouse) file for Social Security, and eventually take required minimum distributions (at age 72)—all of those add income that might disrupt your Roth conversion plan.   

That’s why you have to account for these things in advance as you’re building your plan. 

Conclusion 

A stock market decline can be a great opportunity to do Roth conversions.  You convert more shares of your investments for the same dollar amount that you might have when the stock market was going up.  Then, as the stock market recovers, your investments appreciate tax-free. 

Just be mindful of some of the considerations and pitfalls you might face when you actually start to do Roth conversions so you don’t pay more in taxes than you’re expecting to.  If possible, go over your Roth conversion plan with your financial advisor.  If you don’t have a financial advisor, but would like to learn more about working with one, click here to get started.   


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