How Roth Conversions Can Maximize The Tax Benefits Of A Bear Market

How Roth Conversions Can Maximize The Tax Benefits Of A Bear Market

Bear markets can be stressful for both financial advisors and their clients – particularly for those clients who are near retirement or have recently retired and are therefore especially susceptible to sequence-of-return risk, as a market downturn in the first decade of retirement can negatively impact a retiree’s sustainable spending rates. At the same time, though, market downturns can create favorable tax planning opportunities, including the ability to maximize ‘discounted’ Roth conversions.

While individuals at any income level can complete Roth conversions (unlike making Roth IRA contributions, which have income limits), it does not necessarily mean that doing so will always be the most tax-efficient decision. Because whether traditional or Roth accounts are better depends on that individual’s tax rate today as compared to their expected future tax rate. Typically, this means that it will be advantageous to make traditional contributions (and reduce taxable income) when a person’s marginal tax rate is higher today than it will be when the funds are withdrawn in the future, and Roth contributions (or conversions) when the future tax rate is expected to be higher than it is today.

For investors who do consider making a Roth conversion, a declining market can effectively put the conversion ‘on sale’ at a (hopefully) temporarily depressed value. This is because, as the total value of the account drops, the dollar amount to be converted to a Roth account will represent a larger percentage of the pre-tax account, resulting in a larger portion of the future growth of the account being shifted into a Roth without moving into a higher tax bracket as a more sizable portion of the account is converted.

Notably, the benefits of Roth conversions during a market downturn can also depend in large part on how an individual sources the funds to pay the taxes on the conversion. And when it comes to paying the taxes due, cash is usually king, since using available cash set aside in a savings account – instead of taking funds that could have otherwise been converted to pay those taxes – will allow a larger balance of the tax-free Roth account to enjoy a market rebound. As while the individual might not have wanted to invest the money in the savings account, by using it to pay the taxes due on the Roth conversion, the savings is effectively paying for the future tax-free growth in the Roth account!

In addition, because Roth conversions can be made throughout the year in any amount, certain strategies can help maximize the value of the conversions, minimize potential client regret, and avoid running afoul of the tax rules that govern conversions. For example, conversion-cost averaging (dividing a selected annual conversion amount into regular, smaller conversions throughout the year) and Roth barbelling (converting once at the beginning of the year and again at the end of the year when the client’s tax picture is clearer) can allow for adjustments of the amount converted if a client’s income changes unexpectedly, among other benefits.

Ultimately, the key point is that a market downturn presents an opportunity to convert a higher percentage of a pre-tax account to a Roth account for the same amount of taxable income, for those who otherwise should be doing a Roth conversion given their current tax rate. Because while a down market can be challenging for both advisors and their clients, the opportunity for Roth conversions ‘on sale’ during these periods (when appropriate!) offers advisors the chance to generate tax alpha for their clients!

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