Does a Roth Conversion Make Sense Right Now?

Making regular contributions to tax-advantaged retirement accounts is one of the most effective ways to build financial security over the long run. Given the current state of global stock markets, it’s natural to rethink how you can get the most out of your 401(k)s and IRAs once you’ve built up healthy balances. A popular strategy is the Roth conversion. Here, we’ll briefly review what a Roth conversion is, how one would play out in reality, and if now is the right time to move ahead with one.

How a Roth conversion works

Most people fund their retirement through traditional 401(k)s or IRAs, which usually provide a tax deduction at the time of contribution. These accounts function as tax-deferred accounts; in other words, you trade paying tax today for the obligation to pay at some point in the future (when money is withdrawn or converted.) Along the way, you receive tax-deferred growth, which can help accelerate the effects of compound interest. A Roth conversion is the voluntary conversion of all or a portion of a pre-tax retirement account. Instead of opting for more tax deferral, you choose to declare a portion of your pre-tax investments as income today, ideally to save on taxes in the long run. If you’re still working, you may only be able to do this with your traditional IRA balances, although some companies offer “in-plan” Roth conversions as part of their 401(k) offerings. When you perform a Roth conversion, the amount converted is added to your total income for the year and taxed at your highest marginal tax rate. The advantage to doing this after the market has fallen is that you’ll pay less tax upon conversion; when the market recovers in the future, your money will recover under tax-exempt Roth status. This can be a tremendous advantage to those concerned about exorbitant tax bills in retirement.

Is now the right time for a Roth conversion?

The ideal time to initiate a Roth conversion is at the intersection of two events: a lower-than-usual income year and a time of depressed prices in the stock market. Converting at a time like that allows you to take advantage of lower tax brackets and lower valuations to minimize your long-run tax burden. Now, you may not be in a lower-than-average income year, but the market has already fallen precipitously in 2022. You could hold out for further stock market losses to take advantage of further tax savings, but it’s impossible to know what performance will look like from here. So it’s best to work with what we currently can see. A potential strategy in this scenario is to convert only a portion of pre-tax retirement accounts to Roth IRA while closely monitoring your total income for the year. Roth conversions that are too aggressive can push you into a higher tax bracket (thus defeating the purpose of the Roth conversion), while those that are too conservative might leave you feeling like you missed an opportunity.

How it might look on paper: An example

Let’s imagine that over the course of your working career, you’ve saved up $100,000 in a traditional IRA. For simplicity, let’s also assume that all contributions were tax-deductible (the entire account balance is considered “pre-tax”), and your total income falls in the 24% tax bracket. In this scenario, a full Roth conversion of your $100,000 traditional IRA would cost $24,000 in taxes. However, after the recent downturn, you notice that your traditional IRA account balance has fallen to $75,000. A full Roth conversion, at this point in time, would cost $18,000 in taxes. While oversimplified, this example illustrates that you can save $6,000 in taxes by simply waiting for lower market valuations before converting money to Roth IRA.

Well-planned Roth conversions can help

While there is no consensus “best time” to execute a Roth conversion, you can feel confident that a down market is the right environment to start thinking about one. The most important factor, beyond market performance, is total income; you’ll need to get a strong sense of how much money you intend to earn in aggregate this year and plan your Roth conversions from there. Converting pre-tax IRAs to Roth accounts in years of very high income may not make any sense at all — even if the market has fallen by more than 20%. It’s absolutely imperative that you take Roth conversions in the context of your total financial picture and act accordingly. For additional assistance, it’s sensible to work with a fee-only Certified Financial Planner practitioner or a licensed Certified Public Accountant who can provide additional guidance on the timing and amount of tax-smart Roth conversions.