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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.
Scenario 1: Paying tax from a side account that is invested similarly to the Roth IRA
In this scenario, you pay the conversion tax from a side account that is invested in a very similar manner as your Roth IRA. In other words, the expected risk and return of both accounts would be fairly equivalent.
If you take this approach, then there is absolutely no tax savings generated if the conversion tax is paid prior to the market recovering. This is a very crucial point to understand.
If your side account is invested the same as your Roth IRA, then it also participates in the market downturn. And if you pay the conversion tax from this side account before it has had a chance to recover, then you miss out on any tax savings benefit.
Let’s continue with our example from above.
Even though you paid less tax by converting in the down market ($36,000) compared to the up market ($48,000), this doesn’t mean you actually have a $12,000 benefit.
Here’s why: It all lies in the value of the side account, because the value of the Roth IRA would remain the same (regardless of when you converted), since the tax is paid from the side account.
Let’s assume the side account had just enough money in it to cover the $48,000 conversion tax in the up market. After the tax is paid, the side account is left at a $0 balance.
If you convert in a down market, your tax is less at $36,000, but your side account also declined 25% (remember in this scenario, the side account is invested in a similar manner to the Roth IRA) from $48,000 to $36,000. And thus, your side account is also now valued at $0.
Therefore, no matter when you convert (up or down market), the value of your Roth IRA and the side account will be exactly the same if the tax is paid prior to the market recovery and the two accounts are invested in a similar manner. As such, there is no tax advantage to converting in a down market under this scenario.
Scenario 2: Paying tax from a side account that is invested more aggressively than the Roth IRA
In this scenario, you pay the conversion tax from a side account that is invested more aggressively than your Roth IRA. In other words, the expected risk and return of the side account would be greater than the Roth IRA.
If you take this approach, then there is absolutely no tax savings generated if the conversion tax is paid prior to the market recovering.
The concept is exactly the same as in the above scenario. If you pay the conversion tax from this side account before it has had a chance to recover, then you miss out on any tax savings benefit.
However, there is one added disadvantage with this scenario. Not only does your side account get depleted to $0 (just like in the above scenario), but you now must also come up with extra money to cover the conversion tax. This stands to reason, because the side account is invested more aggressively and therefore declined more than the Roth IRA. That means there is not enough money in the side account to cover the conversion tax. As such, you must come out-of-pocket to make up the difference.
Therefore, if you convert in a down market and the side account is invested more aggressively than your Roth IRA and you pay the conversion tax prior to the market recovering, then you are doing yourself more harm than good.
When does it make sense to do a Roth conversion in a down market?
The only sure way to get a tax benefit when doing a Roth conversion during a down market is to use cash to cover the conversion tax. This ensures that you will always receive the maximum tax benefit available.
If you plan on paying the conversion tax from a side account that is invested the same or more aggressively than your Roth IRA, then the only way to get a tax benefit is to pay the tax after the market has recovered. And, in order to get the full tax benefit, you’ll need your side account to fully recover before the tax is due (April 15th or earlier, if estimated tax payments will be required). But, of course, there is no guarantee that your account will recover before the tax is due.
A Roth conversion is not a slam dunk in a down market.
The next time your investment account suffers a big decline, and before you automatically do a Roth conversion, take into consideration how your side account is invested and when the conversion tax will be paid.
Brad Tinnon is a CERTIFIED FINANCIAL PLANNER™ and founder of B.E.S.T. Wealth Management. He primarily spends his time helping people build a plan for ALL their finances. He can be reached at [email protected].
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
