Cheap(er) Roth conversions are a silver lining in a down market


Almost everything that could go wrong for investors so far in 2022: Stock and bond prices have fallen simultaneously. Even that proven bear market asset – silversaw its advantages eroded by higher inflation.

But as with all market sellouts, there are at least some silver linings. Rising interest rates mean higher bond yields, which will translate into better long-term returns for bond investors over time. And falling stock prices mean the market as a whole is priced more attractively than it was at the end of last year. Companies in Morningstar’s global coverage universe were slightly overvalued in December 2021, but now trade at a 13% discount to fair value. Specific sectors, such as consumer cyclicals and technology, look even more attractive.

Market weakness also presents opportunities for tax-loss selling. Long-held stock positions are still likely to trade above their cost basis, but investors may be able to pick recently bought stocks to generate losses, particularly if using the method of specific identification of cost base follow-up actions. They can use these losses to offset capital gains or up to $3,000 of ordinary income; unused losses can also be carried forward indefinitely in the event an investor anticipates a particularly high tax year (for example, due to the sale of a highly valued asset).

Another potential maneuver to explore in the wake of falling asset prices is converting traditional IRA assets to Roths. Investors who convert will have to pay taxes on all assets never taxed in the traditional IRA (pre-tax contributions and investment income). This means that conversions are generally more desirable when the investor’s own tax rate is at a low level or when portfolio securities areor ideally both.

Right now, both factors align in favor of conversions. With falling stock and bond prices, investors can convert more shares from their IRA holdings for the same tax bill as they should onto fewer shares at higher prices. In addition, secularly higher tax rates could be on the horizon: current tax rates, introduced by the Tax Cuts and Jobs Act 2017, are expected to “set” or return to 2017 levels by early 2026 unless Congress takes action to extend them.

If converting traditional IRA assets to Roth is on your to-do list, here are some of the key questions to ask.

Does a Roth add up?

There are several advantages to holding Roth accounts, especially in retirement. You’ll pay taxes on the money before it goes into a Roth, but once it’s there it enjoys tax-free compounding, and retirement withdrawals are also tax-free, assuming that they erase the five-year rule. Additionally, withdrawals from Roth accounts are not part of the calculation that determines tax on Social Security benefits, and importantly, there are no required minimum distributions on Roth IRAs. (RMDs apply to Roth 401(k), but they’re usually easily circumvented by moving the funds into an IRA.) to Social Security taxation, and they’re also subject to RMDs.

The ability to make tax-free withdrawals from a Roth account in retirement will be especially beneficial if you expect to be in a higher tax bracket in retirement than you are today. If so, it’s better to pay taxes before you put money into the account (like you do with Roth assets) than when you take it out (like you do with traditional IRAs).

Seeking Roth treatment may also make sense if you don’t expect to need some or all of your IRA assets in your lifetime. For people who expect a portion of their IRA assets to go mostly or in part to their heirs and don’t want to have to take RMDs, Roth assets make a lot of sense. Being able to dodge RMDs also gives retirees an invaluable level of control over their tax situation and should allow them to reduce their taxes in retirement. Meanwhile, investors subject to RMD have much less control. The funds must go out and be taxed.

Or not so much?

Despite these Roth virtues, Roth’s contributions and conversions won’t add up for everyone. Those who expect to be in a lower tax bracket in retirement than when contributing or converting traditional IRA assets to Roth will tend not to benefit from Roth assets. These people are also likely to need their IRA assets in retirement, period, so the ability to dodge RMDs won’t be an advantage. Additionally, people who qualify for a tax deduction on an IRA but who contribute to a Roth instead can push themselves into a higher tax bracket, disqualifying themselves for valuable credits and deductions in the process.

For many individuals and families, the signals about whether to go Roth or keep traditional IRA assets are mixed. In this case, it may make sense to do both.keep some traditional IRA assets while contributing or converting some assets to a Roth as well.

Partial conversions often add up

Looking at your total tax chart, not just the conversion, can also help you determine whether it’s best to convert now or wait until a later date. For example, while your traditional IRA balance may be depressed this year, you may also have received a large bonus earlier in the year, increasing your total income and making conversion more expensive than it would be if you expected a drop. taxation year. Meanwhile, new retirees in the post-work, pre-RMD years often have plenty of leeway to cut their income, providing a good opportunity to make IRA conversions. A tricky aspect of this market sell-off is that it came quite early in the year, before investors had complete clarity on their total tax position.

Ultimately, a series of conversions over a period of years often makes more sense than a large conversion in a single year. Just as dollar cost averaging helps ensure you’re not buying stocks at precisely the wrong time, a series of partial conversions helps you diversify your conversion schedule. A valid goal is to convert just enough each year to avoid pushing your income into the next highest tax bracket.

In addition to considering the tax bill related to conversion and its interaction with other income, it is also worth assessing whether you have the funds (i.e. taxable assets) to pay these additional taxes. . If the only way to cover the taxes is to withdraw additional funds from the account, you will trigger taxes, as with any traditional IRA withdrawal, plus an additional 10% penalty if you are not yet 59.5 years old . In addition, you will reduce the amount of assets in your account.

A financial or tax advisor familiar with investment-related taxes can help you determine if and how much to convert as well as the amount of additional taxes that would be due in the year of conversion. For a back-of-the-envelope type calculation, Schwab, Fidelity, and other investment providers also have calculators that allow investors to plug in their IRA balances, how much they’d like to convert, and their tax information, among other factors, to assess the wisdom of IRA conversions and estimate the tax bills they would entail.