Roth Conversions: One Proactive Measure During Bear Markets

The first half of 2022 certainly tested the patience of investors. Both stock and bond prices declined significantly. Stocks entered a bear market, defined as a decline of 20% or more. US large cap stocks, as measured by the S&P 500, dropped 23.6% between the peak on January 3, 2022, and the trough on June 16, 2022. As markets fell, rallied and fell again, investors were bombarded with news, most of it bad, as so-called experts explained every move the market made and went further to explain what was going to happen in the future. During times like this, the discipline of a long-term investment plan is most important.

From the low of June 16, through the close on August 25, the S&P 500 jumped 14.5%, regaining about half of its earlier loss and leaving it only 12.4% below its all-time high of January 3.  This quick upward bounce in prices is a good reminder of how important keeping your cool as an investor can be.  As Bragg portfolio manager Matt DeVries lays out in his 2nd Quarter 2022 Commentary, since 1929, we’ve endured 22 market declines of 20% or more. That’s an average of once every 4.3 years. Of the previous 21 bear markets, the market has recovered 100% of the time. History has clearly demonstrated the difficulty of timing these declines and recoveries. A better approach is to consistently maintain an allocation that is appropriate and to opportunistically rebalance (trim bonds and buy stocks) when the market declines.

In addition to rebalancing, a significant market decline presents other planning opportunities. One technique, a Roth conversion, can be especially appealing when your portfolio value has declined. Benton Bragg’s article Roth IRAs For Everyone details the unique benefits of a Roth IRA and the rationale for converting pre-tax dollars to a Roth. A Roth conversion means moving assets from a traditional IRA to a Roth IRA. You pay ordinary income tax on the amount converted in the year of conversion. Roth IRAs enjoy tax-free growth, and importantly, tax-free withdrawals later in the future. Essentially, by converting pre-tax IRA funds to a Roth IRA, you are accelerating the payment of taxes to shift dollars into a vehicle that will not be taxed again.

Two boxes to check when considering a conversion are 1) you expect that the rate of tax you will pay on the converted amount will be lower than the rate of tax you (or your heirs) would pay on a withdrawal from a traditional IRA in the future, and 2) you have sufficient assets outside your IRA with which to pay the taxes resulting from the conversion. A Roth conversion can prove especially valuable if you expect that it will be many years before you need the Roth dollars or if you plan to leave this income-tax free asset to your heirs.

Converting during a market decline makes sense if you assume that the market will recover because the growth in the assets resulting from the recovering market will occur in the tax-free environment of the Roth. This can be a powerful tool! Consider a simple example: A traditional IRA declines in value from $500,000 to $400,000 during a bear market. This IRA worth $400,000 is converted to a Roth IRA and taxes are paid (with outside assets) on the $400,000 conversion. The market fully recovers and the $400,000 Roth is now worth $500,000. Will your timing be this perfect? Hardly! It will be hard to get it just right. With the benefit of hindsight, we can say that a conversion today would have better results than a conversion at the market high on January 3 and likewise, a conversion on the market low of June 16 would have been the best time this year (so far) for a conversion, as that is when prices were the lowest. Just as with timing the stock market, only with hindsight will we know the best day for a conversion. The point is simply that it is worthwhile to consider the level of the market carefully when contemplating a conversion to a Roth. The lower the market, the better!

This article is relevant now and will be relevant again in the next bear market. We’re always heading towards the next bear market; it is critical to make good decisions when they occur so you can reap the benefit of the bull markets in between.

This article focused on Roth conversions and the benefit of making conversions during market declines.  There are other opportunities to take advantage of the unique tax benefits offered by Roth IRAs. These include making annual Roth contributions directly, making “backdoor” Roth IRA contributions or even making Mega Backdoor Roth 401(k) contributions. As always, rules, regulations, and limitations apply! Please feel free to consult Bragg if you would like to explore the alternatives. You should also consult your tax advisor before taking action. Thank you for trusting Bragg Financial with your planning and investing.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.