Roth Conversions During Market Downturns

Practical Planning During Market Swings

TL;DR
Market downturns are unsettling, but they also open a short window for a few proactive planning steps.

• Roth Conversions take pre-tax money and move it into your Roth account for tax-free growth and future withdrawals. The aim is to lower your lifetime tax bill. 
• Converting a smaller account balance when the market is down, lowers the taxes you pay this year, while letting the rebound occur tax-free in your Roth account
• For investors with mostly pre-tax dollars, building a Roth accounts adds flexibility for your portfolio and for long-term tax planning

A Refresher on Roth Conversions

A “Roth Conversion” refers to transferring funds from a Traditional pre-tax retirement account to a Roth IRA. The amount you convert is taxable income in the year of the conversion, but once the conversion is done that amount can grow, and be withdrawn, tax free

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The Downturn Planning Window

The center of Roth Conversion planning is believing that paying taxes today helps you achieve paying lower taxes across the other years of your life. Whether this is true or not requires some assumptions and is unique to your family’s plans. The right way to weigh the decision is looking at scenarios side by side like this example.

Here are 4 ways that taking advantage of market downturns serve this strategy:

1. Lower Taxes on Converted Amounts: Down markets (unfortunately) mean a smaller balance in your Traditional IRA. Converting during this period means you're paying taxes on that smaller amount today, versus on the withdrawals on a larger amount later on.
2. Potential for Greater Tax-Free Growth: Roth IRAs offer tax-free growth and withdrawals in retirement. By converting when asset values are low, you position yourself for more of your gains to be tax-free as the market rebounds. 
3. Rebalancing and Tax Location: A market downturn might have shifted your portfolio's asset allocation. Roth conversions can be an opportune time to rebalance. For investors who have most of their assets in pre-tax accounts, this may also be a good time to look at your family’s entire portfolio (across all accounts) and make sure the investments you have are in the best type of account. We call this process “asset location”, for example having the highest growth assets in a Roth account. 
4. Long-Term Tax Planning: The core idea behind all Roth conversion planning is expecting that you can pay taxes at a lower rate this year than you will at some point in the future. By paying taxes now at potentially lower rates, you avoid higher taxes on withdrawals from pre-tax accounts later. Current rules also mean that Roth accounts can grow and be passed to heirs tax free, another bonus for investors who currently have the bulk of their money in traditional retirement accounts. Market swings have the potential to make both of these tactics higher impact.

Considerations for Roth Conversions

1. Tax Implications: The amount converted is added to your taxable income. You'll need to look at your current tax situation and determine if the conversion makes sense.
2. Ability to Pay Taxes: Ensure you have the funds to pay the taxes due on the conversion without depleting your retirement savings. While you can pay taxes from your retirement account, the better route is to pay the taxes owed from cash you have on hand.
3. Time Horizon: Roth conversions have the biggest impact on dollars that can remain invested for the long-term allowing ample time for tax-free growth.
4. Consult with Your Team: Naturally, investors should consult with their own advisors before making any decisions. Take a look at your individual circumstances and determine if a Roth conversion aligns with your financial goals.

     Market swings are scary [no citation needed], but they also offer strategic planning opportunities. Performing Roth conversions during these times can potentially reduce your lifetime tax burden, position you for greater tax-free growth, and serve your long-term financial planning goals. Our belief is simply that wealth is built and preserved in strategic planning gaps like these.

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