Roth Conversions are More Valuable During Bear Markets

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For many investors glued to the news, the global outlook appears to be perilous with no prospects of growth for the world economy. Just a few days ago, our 2020 market corrections officially turned into a Bear Market.

A Bear Market is defined as an index dropping at least 20% from some previous high. Smaller drops in the market between 10% and 20% are called “corrections” while larger drops of at least 50% are called “crashes.” Prior to this month and since 1950, there had been exactly nine Bear Markets in the S&P 500 Price Index (the most common representation of “the market”). Only one of those turned into a stock market crash. The other eight stopped dropping before the loss from peak to bottom was greater than 50%. In mid-March 2020 though, we slid into a new Bear Market for 2020 with daily dramatic dips that remind us of 2008.

Our brains are not designed to handle such volatility. Our brains are designed to pull our hand off a hot stove quickly. “We’re losing money! Get out!” our emotions scream. However, with investing, getting out of the markets after they have already gone down is often terrible advice. You shouldn’t let short-term volatility ruin a brilliant investment strategy. And in the markets, short-term is everything from this dramatic daily volatility to even a decade of returns.

The stock market is inherently volatile, but it is also inherently profitable. Everyone would want to have invested as much as possible 30 years ago, even knowing all the so-called crises that were on their way. Long-term investing erases all this short-term volatility.

For this reason, Bear Markets represent a great opportunity for Roth conversions.

A Roth conversion is the process of moving assets from your traditional IRA into a Roth IRA. Roth IRAs are unique because the investment growth is never subject to taxation – even when the assets are distributed from the account. Roth conversions can avoid future Required Minimum Distributions (RMDs), enhance the value of your estate, and smooth your tax burden across several years.

Systematic Roth conversions, where you convert some of your IRA each year as part of a larger strategy, can be worth millions of dollars. However, even just one Roth conversion in one year can be extremely valuable.

A Bear Market represents a great time to convert for the same reason that you may have anxiety at night: Your IRA is worth less right now.

Let’s imagine a family that as part of a simple systematic Roth conversion strategy planned to convert under a Medicare Surcharge Income Related Monthly Adjustment Amount (IRMAA) AGI line with a conversion of approximately $100,000. Imagine that before a Bear Market, they had an IRA worth $1M. Then, the markets went down 20%, and now it is only worth $800,000. Regardless of when they convert, the tax on the $100,000 will be the same on their tax return.

If they convert before the Bear Market, a $100,000 conversion represents 10% of their IRA value. However, if they convert during the Bear Market, the same size conversion represents 12.50% of their IRA value.

For the same tax owed, they can get a larger percentage of their IRA into Roth. Then, a larger percentage of their retirement assets will be in a tax-free environment when the markets recover under the next Bull Market.

Again, let’s imagine a different family is converting one tenth of their IRA as part of a simple strategy to empty their IRA before RMDs begin. They could, instead of converting the full $100,000 they previously calculated would be required, only convert $80,000 after a Bear Market to represent the same one tenth target percentage of their IRA. This accomplishes their full Roth conversion strategy while saving them money on their taxes this year. If they are converting in the 24% bracket for example, that might save them $4,800 (24% of $20K) on this year’s taxes.

No one, us included, can successfully identify market tops or bottoms or insulate you from losses due to market corrections or crashes. There is no way of knowing how long the markets will go down or how long it will take for them to recover.

You may convert a large sum only to see the markets drop more and wish you had waited to convert later. You may put in your instructions to convert on the exact day that the markets recover.

Although there exist some timing strategies such as this one that can theoretically gain an advantage, in the end, market timing strategies, including timing your Roth conversion, give way to the long-term trend of the markets.

Even if you convert at the “wrong time,” it is likely still better that you converted. Roth IRAs are amazing tax saving tools, and the long-term benefits can be significant.

Plus, we believe that the markets are relatively efficient over long periods of time. The returns of the markets are like a whip being cracked up and down by someone riding an escalator slowly up. You’ll get dizzy tracking the tip of the whip, but if you take a long-term perspective and watch the escalator, you’ll be able to relax and enjoy the ride.

Convert something today. Convert because the markets are down, or maybe convert just because you likely won’t regret it in 30 years when the markets will likely be up a lot more than they are now.

Image by THE 5TH from Pixabay

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Chief Operating Officer, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine