Cheap(er) Roth Conversions Are a Silver Lining in Falling Market

Almost everything that could go wrong for investors has so far in 2022: Stock and bond prices have slid simultaneously. Even that tried-and-true bear-market asset—cash—has seen its benefits eroded by higher inflation.

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

Market weakness also presents opportunities for tax-loss selling. Long-held equity positions are still likely to be trading above their cost basis, but investors may be able to cherry-pick recently purchased shares to yield losses, especially if they’re using the specific share identification method of tracking cost basis. They can use those losses to offset capital gains or up to $3,000 in ordinary income; unused losses can also be carried forward indefinitely in case an investor anticipates a particularly high tax year (for example, because of the sale of a highly appreciated asset).

Yet another potential maneuver to explore in the wake of declining asset prices is the conversion of traditional IRA assets to Roth. Investors who convert will owe taxes on any never-been-taxed assets in the traditional IRA (pretax contributions and investment earnings). That means that conversions are generally more desirable when either the investor's own tax rate is at a low ebb or when the securities in the portfolio are—or ideally both.

Right now, both factors are lining up in favor of conversions. With stock and bond prices down, investors can convert more shares of their IRA holdings for the same tax bill that they would owe on fewer shares at higher prices. Moreover, higher tax rates secularly might be in the offing: The current income tax rates, ushered in by the Tax Cuts and Jobs Act of 2017, are set to “sunset,” or revert back to 2017 levels, at the beginning of 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 of holding Roth accounts, especially in retirement. You'll pay taxes on the money before it goes into a Roth, but once it's in there, it enjoys tax-free compounding, and withdrawals in retirement are also tax-free, assuming they clear the five-year rule. Additionally, withdrawals from Roth accounts aren’t part of the calculation that determines the tax on Social Security benefits, and importantly, there aren’t any required minimum distributions on Roth IRAs. (RMDs do apply to Roth 401(k)s, but they’re usually easily circumvented by rolling the funds into an IRA.) By contrast, traditional IRA assets are taxed at your ordinary income tax rate upon withdrawal, withdrawals from them do contribute to Social Security taxation, and they’re also subject to RMDs.

The ability to take tax-free withdrawals from a Roth account in retirement will be particularly advantageous if you expect to be in a higher tax bracket in retirement than you are today. If that's the case, it's better to pay taxes before you put money into the account (as you do with Roth assets) than when you take it out (as you do with traditional IRAs).

Seeking Roth treatment can also make sense if you don't expect to need all or part of your IRA assets during your lifetime. For people who expect that a portion of their IRA assets will go mainly 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 situations and should allow them to reduce their taxes in retirement. Meanwhile, RMD-subject investors have much less control. The funds have to come out and be taxed.

Or Not So Much?

Despite those Roth virtues, Roth contributions and conversions won't add up for everyone. Those who expect to be in a lower tax bracket in retirement than when they are contributing or converting traditional IRA assets to Roth will tend not to benefit from having Roth assets. Such individuals are also likely to need their IRA assets in retirement, period, so the ability to dodge RMDs won't be a benefit. Moreover, individuals who are eligible for a tax deduction on an IRA but contribute to a Roth instead may 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 retain traditional IRA assets are mixed. In that case, it can be sensible to do both—retain some traditional IRA assets while contributing to or converting some assets to a Roth as well.

Partial Conversions Often Add Up

Looking at your total tax picture—not just the conversion—can also help you size up whether you’re better off converting now or waiting until some future date. For example, even though your traditional IRA balance may be depressed this year, you may also have received a big bonus earlier in the year, plumping up your total income and making the conversion more costly than it might be if you waited for a lower-tax year. Meanwhile, new retirees in the postwork, pre-RMD years often have a lot of latitude to keep their incomes down, providing a good opportunity to conduct IRA conversions. One tricky aspect of this market selloff is that it has come fairly early in the year, before investors have complete clarity on their total tax pictures.

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

In addition to thinking through the conversion-related tax bill and its interplay with other income, it’s also worth assessing whether you have the funds on hand (that is, taxable assets) to pay those extra taxes. If the only way to cover the taxes involves pulling additional funds out of the account, you’ll trigger taxes, as with any traditional IRA withdrawal, plus an additional 10% penalty if you’re not yet 59.5 years of age. Plus, you’ll reduce the amount of assets in your account.

A financial or tax advisor well versed in investment-related taxes can help coach you on whether and how much to convert as well as the amount of extra 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 enable investors to plug in their IRA balances, how much they’d like to convert, and their tax information, among other factors, to gauge the wisdom of IRA conversions and estimate the tax bills they’d entail.