How a Bear Market can Increase the Value of Roth Conversions
Since the Tax Cuts and Jobs Act lowered the marginal tax bracket for many Americans, Roth Conversions have become very popular. Now, in 2022, we're facing a bear market in addition to historically low tax rates. Depending on your personal situation, these factors might make it an ideal time to convert some of your pre-tax retirement savings into Roth dollars.
How does a Roth Conversion work?
1. You currently have some form of pre-tax retirement savings.
This could be in a 401k, traditional IRA, or other similar retirement account. These savings reduced your taxes when you contributed to the plan, but all future withdrawals (savings and growth) will be taxed at ordinary income tax rates. This is good if someone is in a high income tax bracket when they save the money, and expect to be lower when withdrawing it in retirement.
2. You (and your tax advisor) feel that your savings would be more advantageous in a Roth (401k, IRA).
Roth accounts contain after-tax savings (you do not receive any tax deduction for your contributions), but if you meet the IRS requirements, withdrawals from Roth accounts are tax-free (both savings and growth).
You choose an amount to convert from pre-tax to Roth.
- That amount is added to your taxable income for the year, but now the funds can grow tax-free in the Roth account (if the individual meets the IRS requirements at distribution).
Why do a Roth Conversion?
There are a several reasons that someone might choose to convert some of their savings to Roth:
- They feel that they are in a lower tax bracket now than they will be in the future, either because of a future increase in income, or a future increase in federal income tax rates
- They don't want to take Required Minimum Distributions at age 72 (pre-tax retirement savings have this requirement; Roth IRAs do not)
- They want their savings to grow tax-free instead of deferring taxes to a future date
- They anticipate passing retirement savings to heirs and wish to pay taxes at their own tax rates, rather than making the heirs paying the tax at the heirs' tax rate (which could be higher).
These are some of the reasons that Roth Conversions were already a popular option for retirement, tax, and estate planning. The lower tax brackets and higher standard deductions that came with the 2017 Tax Cuts and Jobs Act only made these conversions more appealing.
How can a Bear Market help?
Stocks across the globe have been hit hard this year. Whether we're in a recession or not remains to be seen (some indicators say yes, others say no), but the stock market certainly thinks it's a real possibility. Add in rates of inflation not seen since the 1980s, the rapid increase in interest rates, and weaker corporate earnings - this has all resulted in the S&P 500 Index dropping more than 20% from the most recent peak. This is the definition of a "Bear Market." Bonds, commonly used in portfolios as a safer investment than stocks, have also seen a decline this year due to rapidly rising interest rates (although they have not declined as far as the stock markets).
For individuals already in retirement and withdrawing from retirement accounts, the decline in investment balances can be understandably worrisome. However, for those considering Roth conversions, this may be an ideal time.
An investment portfolio is not just the account balance that you see on a statement; the portfolio likely holds hundreds or even thousands of individual securities (stocks or bonds) within it. The statement shows the value of all those holdings, if you were to sell them all that day. However, just because your account balance declined, doesn't mean you lost stocks or bonds.
For example: let's say you purchased a share of a stock for $100 on January 3rd, 2022. Today, that stock has dropped to $80 on the New York Stock Exchange. Your statement, understandably, shows that the value of your account is now $80 - the value you can get if you sell that stock today. However, you still own the same 1 share - you didn't lose the physical stock just because the value dropped.
How does this help Roth Conversions?
When you choose to perform a Roth Conversion, you set a target value of the conversion that will be added to your taxable income for the year. When the value of the investments is lower, you can actually convert more shares for the same price tag.
- Imagine that you have an IRA that was worth $100,000 dollars on January 1, 2022. Your portfolio consists of 1,000 shares of an index fund trading at $100 each.
- Your tax advisor recommends converting $50,000 of your portfolio to a Roth IRA. If you convert on January 1st, you would convert 500 shares of your index fund, and $50,000 is added to your taxable income for the year. If you're in the 22% tax bracket, this would result in additional taxes of $11,000.
- You now have equal amounts in your pre-tax and Roth IRAs. Assuming they are still invested the same way, half of your future growth will come tax-free in the Roth - but half is still in the traditional IRA and taxes will be due upon withdrawal.
After a Bear Market hits:
- The value of your portfolio declines to $80,000. You still own 1,000 shares of the index fund but it is now trading at $80 each.
- Your tax advisor still recommends a $50,000 Roth conversion. Now that the shares are trading at $80, you convert 625 of them instead of 500. 375 shares are left in the traditional IRA.
- You pay the same tax bill of $11,000; however, now more shares are in your Roth account than if you had converted on January 1st.
- When the index fund recovers and starts to grow again, you are now capturing more of the growth in the tax-free Roth IRA, instead of in the tax-deferred IRA where future growth is still taxable. While you paid the same tax bill today, you lowered the amount remaining to be taxed in the future.
A low stock market means that you can convert more shares for the same tax burden than you could previously. Alternatively, you could convert the same number of shares for a lower tax bill.
Of course, there are many factors to consider before completing a Roth Conversion. You should always consult with your tax advisor on the full implications. However, it does offer a silver lining in a bad market year, for those who can take advantage.
This blog post, including the views and opinions contained herein, is being provided for informational purposes only, and it should not be relied upon in making any investment decision. This blog post does not constitute investment, tax, accounting, or legal advice, nor does it constitute a recommendation or offer to buy or sell any security or financial product. To the extent that the recipient has any questions regarding the applicability of any information discussed herein to their specific portfolio or situation, the recipient should consult with the investment, tax, accounting, and/or legal professional of their choosing.