Should you do a Roth conversion when the market goes down?

Market downturns are often a good time to convert your retirement accounts. Here are some things you should consider.

This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.

What’s a Roth conversion?

A Roth conversion moves money from your Traditional IRA or 401(k) to a Roth IRA or 401(k). You pay ordinary income taxes on the amount you move. Since the money stays in a retirement account, there’s no penalty.

Why would you want to do a Roth conversion?

There are several reasons you may want to do a Roth conversion.

  • Lower your taxes in retirement. You may expect your required minimum distributions, pension, Social Security, investments, or other income to leave you in a high tax bracket in retirement. If you convert before that income kicks in, you may be able to do so at a lower tax bracket.
  • Take advantage of a low tax bracket now. If you’ve lost income, you may be in a lower tax bracket than normal. Doing the conversion now lets you take advantage of that lower rate.
  • Markets down equals less taxes. Since your account value is lower, you may be able to save on taxes now by converting it at today’s value versus at higher values.

Why would you not want to do a Roth conversion?

There are also reasons not to do a Roth conversion.

  • You need non-retirement cash to pay taxes. You will need to use non-retirement cash savings to pay the tax bill on the conversion. If you have taxes withheld or withdraw from your retirement account to pay taxes, you’ll owe the usual penalty for early withdrawals.
  • You might not owe taxes in retirement. You will still receive a standard deduction in retirement. For 2022, that means you could withdraw up to $12,950 from your Traditional IRA or 401(k) tax-free assuming you had no other taxable income. If all your money is in Roth accounts, you won’t be able to take advantage of that deduction.

Watch out for market volatility.

During times like COVID-19 or financial market panics, it’s not uncommon for the market to make 10% or greater swings in a day. There are two ways this makes conversions dangerous.

  • If you’re trying to very precisely plan your taxes, such as by staying $1 under a certain cutoff, it can be hard to know exactly how much you’re converting during high volatility. This applies more for stocks and ETFs where you request to convert a certain number of shares. For mutual funds, you can usually do it by dollar amount.
  • If you have to sell and rebuy shares, you could lose (or gain) money during the transfer. This doesn’t apply if your broker lets you convert your actual shares. However, some make you sell everything, then transfer the cash, then buy what you want at your new broker.

There are special rules for 401(k)s.

  • You generally can’t convert a 401(k) to an IRA if the 401(k) is for a job you still have. You can convert 401(k)s from other jobs.
  • Whether you can convert a deductible 401(k) to a Roth 401(k) depends on your employer. Some plans let you, while others don’t. It’s mostly an administrative issue due to how complicated 401(k)s are to set up and manage. If your employer doesn’t allow conversions, you can ask them to add the option.

Conclusion

A Roth conversion is a smart tax move that trades paying a little extra in taxes today for bigger savings in retirement. Like any financial move, whether it’s the right move for you depends on your current financial situation and long-term goals.

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