The Bear Market Roth Conversion
Finding the Silver Lining of Opportunity in a Bear Market
A bear market is a term used on Wall Street to describe a drop in an index like the S&P 500 of 20% or more from a recent high over a sustained period.
While the 2022 bear market is eliminating many of the gains the markets made in 2021, it may not be the time to exit the market completely especially if you are more than 5 years away from needing your retirement funds. While there is much debate about how long this bear market might last and how low it will go but working with a financial advisor will ensure that your financial plan is built to survive the ups and downs of the market.
One opportunity that a bear market does create is the opportunity to convert a taxable retirement account to a Roth IRA. Let’s review the differences under current law between a traditional IRA/401k and a ROTH IRA/401k:
With traditional IRA/401k plans:
the contributions are usually tax deductible (unless you exceed income limits).
withdrawals at age 59 ½ and older are fully taxable at ordinary-income rates just like wages.
starting at age 72, the IRS will require you to take a distribution.
With Roth IRA/401k plans:
the contributions are in after-tax dollars.
the withdrawals (including investment gains) can be tax-free.
Roth owners are not required to take withdrawals during their lifetime and the funds can be used for generational wealth transfer.
You can convert a traditional IRA/401k to a Roth IRA by moving assets from the traditional account to a Roth IRA and paying the income tax bill based on the value of the transfer. The transfer value is based on investment prices on the day of the transfer so the overall value will be significantly less in a bear market.
This tax bill can be stiff, and there’s no assurance future growth will compensate you for having accelerated your tax bill. But converting when prices are down puts more income beyond the reach of the IRS when prices recover and grow. There are a myriad of factors that determine whether a Roth conversion makes sense for you. Here are four keys issues you should consider before contacting your tax and financial advisor for additional analysis.
Tax rate at conversion vs. tax rate at withdrawal
If the tax rate on the Roth IRA conversion is lower than the expected rate when the assets would be withdrawn, that weighs in favor of a conversion. If the rate at conversion is higher than the expected rate at withdrawal, that weighs against. Therefore, you should try to complete Roth conversions in lower-tax-rate years.
A full conversion could make sense for a retired dentist that has not started taking required IRA payouts, or for a young dentist who has traditional 401k savings but just bought their first practice.
If you are at least ten years into practice ownership and in your prime earning years, you may want to consider a partial Roth conversions over several years to avoid income that pushes you into a higher tax bracket.
Asset prices
The lower prices are, the lower the tax bill on a Roth conversion often is. That’s is a fantastic opportunity as long as you have the flexibility to hold them through the recovery.
Ability to pay the tax bill with non-retirement funds
The taxes created by the conversion are due by the following tax deadline so you will need cash reserves to pay the taxes created by the Roth conversion. If you can’t pay the tax bill on a Roth conversion with non-retirement funds, you probably shouldn’t convert due to the shrinkage in funds that can grow tax-free.
State and local taxes
State and local taxes on traditional and Roth IRA contributions and withdrawals vary greatly, so take them into account when analyzing a conversion. If you are considering a move from a high-tax state like California to a low-tax state like Texas, you may want to consider holding off until after the move.
Leaving an IRA to nonspouse heirs
Leaving Roth IRAs to nonspouse heirs, such as grandchildren, will often provide them more flexibility than leaving them traditional IRAs.
Both types of accounts often must be emptied within 10 years of your passing, but heirs of Roth IRAs can wait until the end of the 10 year term to withdraw their tax-free funds. Heirs of traditional IRAs must take annual taxable withdrawals if the owner died after age 72.