Roth Conversion in a Down Market? – Think Again

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Much was written about a strategic “opportunity” to do a Roth conversion when the coronavirus caused the stock market to decline over 30% between February and March 2020. The tactic was based on a tremendous tax savings that you would receive. But this is not always the case.

Here is why.

If your IRA investment account was originally valued at $200,000, but declined 25% to $150,000, you could convert to a Roth IRA and only pay tax of $36,000 (24% tax bracket) on the $150,000 conversion. However, if you would have converted prior to the stock market decline you would have paid tax of $48,000 (24% tax bracket) on the $200,000 conversion. It seems that you save $12,000 in taxes by converting in the down market.

But not so fast…

There are two common scenarios that do not produce any tax savings at all when converting in a down market: (1) when you pay tax from a side account that is invested in a similar manner as your Roth IRA; or (2) when you pay tax from a side account that is invested more aggressively than your Roth IRA.

Before I discuss each scenario, I want to explain the “side account” mentioned above. To cover the tax on a Roth conversion, you wouldn’t want to use proceeds from the IRA. Using the IRA to cover the tax would result in more taxes, thereby reducing the benefit of the conversion. So, instead of using the IRA, you would use a non-IRA investment account (i.e. a side account).

Now, let’s discuss the two scenarios.