By Greg Lohr, MBA and Ethan Lohr, CFP®
Think bear markets are all bad? Think again. While seeing your account value drop in an economic downturn is not enjoyable, these bear cycles often present rare opportunities. Who doesn’t love a sale? While bull markets and all-time highs are exciting, market downturns let you buy at lower prices. You can also implement tax strategies that can save you money long term. One tax strategy that can be particularly compelling in a bear market is the Roth conversion.
Seize Opportunity When Prices are Low
Former Wall Street money manager Shelby Davis once said, “You make most of your money in a bear market; you just don’t realize it at the time.” The problem is that fear often prevents people from taking action. Instead of seizing the opportunity to take action, our natural instincts often prompt us to sit tight and not do anything.
But action in the form of proactive tax planning can help you save valuable tax dollars, now and in the future. One way to do that is to do a partial or full Roth IRA conversion. That’s part of the full-service financial planning Lohr & Company provides for all of its clients, and we’ll walk through this process in this article.
Why is the Roth IRA so Popular?
Roth IRA retirement accounts are immensely popular. There’s a reason for that. Traditional IRA accounts offer you an upfront tax deduction on your contribution. Then, the balance grows tax-deferred. Once you reach age 59 1/2, you’ll be able to withdraw from the account, but you will pay ordinary income tax on everything you take out.
Roth IRAs are different. You contribute after-tax dollars, so you forgo the upfront tax deduction. In return, you get tax-free growth. Everything in the account can be withdrawn tax-free in retirement, as long as you follow the rules.
Along with these benefits, a Roth IRA has no required minimum distributions (referred to as “RMDs”). Instead, RMDs are only required after the death of the Roth IRA owner. i
Because of their unique advantages, Roth IRA contributions are limited. For 2022, individuals can only contribute $6,000 per year plus an additional catch-up contribution if they are age 50 or older. ii If you have a high income (or are married and filing separately), you may not be able to contribute to a Roth IRA at all because contributions are phased out for high earners. iii In these instances, we look to employer-sponsored retirement plans as potential means for Roth-designated retirement savings.
What if You are Not Eligible for a Roth IRA Contribution?
Fortunately, even if you earn too much to contribute, there are other ways to create a Roth IRA. One is by converting to a Roth IRA.
That means taking your traditional IRA and, at a later time, following a process to convert it to a Roth. Once you do that, you’ll get your account growing tax-free.
There is a catch, however. A traditional IRA is pre-tax, so you get a tax deduction when you contribute. If you later decide to do a full conversion of one of these pre-tax IRAs into a Roth, you must pay tax on the current value of the account.
That is where the opportunity lies in finding the right timing.
Roth Conversions during a Bear Market
Bear markets are inevitable. While it can be distressing to see stock prices trade in bear market territory, it is a natural part of the market cycle. While it might be easy to blame events like the war in Ukraine, Federal Reserve actions on interest rates or even World War II, stock market cycles are not necessarily related to events. They are more like the seasons. Fall will arrive dependably after summer, although it might come earlier or later than expected in the short term. The good news? Even though many people have bad memories of past bear markets, such as the dot com bubble, these markets are usually short. History tells us the average bear market is dramatically shorter (9.6 months) than the average bull market (2.7 years). iv
When most stock prices drop in a bear market, this is an ideal time to convert an account. You’ll pay less in taxes.
Here’s how it works. When you do the conversion, the IRS considers it a taxable event. That means the amount you convert will be reported as ordinary income tax for the tax year. After that, it becomes a Roth account, enjoying tax-free growth.
No Income Limits on Roth Conversion
One key aspect is that there are no income limits on Roth conversions. Anyone can convert a traditional IRA to a Roth.
Now, just because you can convert to a Roth doesn’t mean it is always in your best interest. If not planned carefully, you may convert a traditional IRA when it isn’t favorable to do so. A careful analysis of your retirement plan needs to be done to ensure it is the best course of action.
Is a Roth Conversion Always the Right Choice?
When might it not be prudent to convert? Suppose you’re on track for a high-income year. In that case, the additional income from the Roth conversion might push you into a higher tax bracket. This might offset the benefit you’re getting from depressed stock prices.
It often seems that since the account grows tax-free, Roths would always be the better choice. Surprisingly, if you run the numbers, that is not the case.
The critical question: do you believe your tax rate will be higher or lower in the future?
If your tax rate remains the same as it is today, there is no benefit to doing the Roth conversion.v However, if your tax rate is higher in the future, you will likely benefit.
There’s a Tax Planning Strategy for That
Of course, there may be other reasons you want tax-free income. Having part of your retirement savings in an account that allows tax-free withdrawals can be a valuable tool in managing your annual taxable income in retirement. So waiting to do the conversion during a bear market makes sense to save you money.
You might be getting a sense of the immense value of proactive tax planning. The biggest problem? Few financial professionals spend enough time on it.
Bottom line, seeing the Dow Jones Industrial Average and other indexes in the financial markets swoon may mean a bear market has arrived. Fear not…if you play it right, these markets might just put more money into your pockets over the long run. You’re in good hands if you have a financial advisor who proactively helps you with this type of tax planning. If you don’t, talk with your tax advisor or consider switching to a more full-service financial advisory firm.
Converting from a traditional IRA to a Roth IRA is a taxable event. Lohr & Company, LLC does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
i https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions#:~:text=You%20generally%20have%20to%20start,the%20death%20of%20the%20owner.
ii https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
iii https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022
iv https://www.hartfordfunds.com/practice-management/client-conversations/managing-volatility/bear-markets.html
v https://www.kiplinger.com/retirement/retirement-plans/roth-iras/601626/6-reasons-you-should-not-do-a-roth-conversion
