If you think that cover photo looks like some “clickbaity”, cheaply done, PowerPoint thing… you would be correct…
Should You Convert a Your 401K or Traditional IRA to a Roth When the Market is Down?
Sticking with one of our favorite themes on this blog, let’s talk more about tax optimization.
The market is currently in the “crapper” (Technical Term) and everything appears to be going on sale. This means that many people are seeing their portfolios shrink on a daily basis. They are hoping that the bottom is close so that we can move on. (Unless you are one of the ones trying to take advantage of the sale!)
During this time, does it make sense to go ahead and pull the trigger on a Roth conversion (401k or Traditional IRA into the Roth equivalents)?
This question turned into a conversation that I had with a co-worker the other day. It comes with two main arguments that can trick us into making potentially sub-optimal decisions.
With portfolio values at much lower levels than they were last year, we should have a lower tax bill, correct?
This statement is most likely true, but only considers the actual tax dollar amount paid now vs a year ago. It fails to justify a conversion because it does not account for any future projections.
It is better to pay the taxes on $100k today than on $1M dollar in the future (assuming the $100k would grow to $1M at some point if left invested).
This second argument makes a lot of assumptions in the background that aren’t obvious at first.
Doing a Roth conversion today may be the correct thing to do in your situation, but it could also be the suboptimal thing to do. Much more information is needed to make a decision; but one thing is for sure, don’t make decisions like this without understanding the entire impact.
Let’s break it down to discuss why.
We need to get some assumptions out there first:
- We will consider a portfolio with a 2021 peak value of $100k
- Current portfolio value is $70k (loss of $30k from the peak)
- We will use a default tax rate of 22% for all money in all scenarios just to simplify the process.
- Taxes that are owed for the conversion will be paid from the balance of the account. This is to make the two options comparable. We will discuss more about paying taxes with “other money” at the end of the post.
Note: The flat tax rate assumption of 22% is an over simplified example created to get the point across for the long-term effects of converting money into Roth. For better understanding of tax brackets, see our last post.
Based on our assumption of a flat 22% tax rate, the actual tax dollars owed on the $70k would be less than the taxes owed on $100k if the conversion was done last year.
That is a $6,600 savings on taxes and the money will never get taxed again. What a deal!
Or is it? It really doesn’t matter. You already lost the $30k due to the market drop. The only thing that matters at this point is “what is the best option today?”.
So let look at how our decisions today can effect the future.
Don’t forget our assumption #4. We will have to reduce the 2022 account balance in order to pay for the taxes if we decide to do the conversion. This also means that the money used to pay the taxes will no longer be available to grow in the account. To better illustrate this, lets drop in a chart. We will use an 8% annual return in the market for the purpose of these projections.
Green Line – Represents the value of the portfolio that was already lost due to the market drop.
Red Dashed Line – Represents the projected value if all of the money is left invested in the pre-tax account.
Blue Dashed Line – Represents a reduced balance due to taxes paid followed by the remaining value growing over time in an after tax account.
Ok, so we can now at least visualize the impact of paying the taxes today. One last thing needs to be reviewed before we can get to the point. What is the difference in value between the two accounts in the future?
The difference in the portfolio balances is 22% which also happens to be the amount that will be owed in taxes on the pretax option. The pretax option has more total dollars in it but only because it has not been taxed yet. Once the taxes are paid out, we are left with the exact same values. As long as tax rates and investment assumptions are the same on both ends, the difference is $0.
The conversation about doing a Roth conversion needs to be about what your tax bracket is today and where it will most likely be in the future. If there are no differences in tax rates, then the final value coming back to you in retirement will be the same either way. The correct question to ask yourself when making this decision is the same as we discussed last post:
- If your situation will most likely put you in a higher tax bracket in retirement, do the conversion now.
- If you are projected to be in a lower tax bracket in retirement, then leave your money in pre-tax.
Also, be sure to remember that when you do the conversion it will be considered income and can bump you up into much higher tax brackets.
Paying Taxes With “Other Money”
If you decided to leave your account intact and pay for the taxes on a conversion with money that was not part of the account, it will come out ahead of the pre-tax option. This has nothing to do with tax rates though. It is because you are essentially pouring more money into the conversion. If you took that same money and invested it into the pretax option, then the scenarios are back to being the same (assuming same tax rates).
One Last Thought:
There are other benefits besides tax savings when doing a conversion.
- Roth accounts do not have minimum distributions because they have already been taxed
- Conversions into a Roth IRA can be accessed after a 5 yr vesting period without the penalty
As always, be sure to look at the full picture.