Current Bear Market Creates Opportunities for Roth Conversions

The Roth IRA, created by the Taxpayer Relief Act of 1997 and named after Senator William Roth of Delaware, is an option for individuals to increase retirement savings. Taxpayers do not receive a tax deduction for Roth contributions, but retirement distributions are tax-free—which means gains on investments in a Roth IRA are never subject to tax.

For traditional IRAs and other defined-contribution retirement plans, such as the 401(k) plan, there are tax benefits for contributions, but all retirement distributions are taxed as ordinary income.

Many taxpayers did not qualify for Roth IRAs due to strict income limitations. However, the IRS permits taxpayers to convert traditional IRA funds to a Roth IRA. While the stock market is down about 20 percent in 2022—a bear market is marked by a 20 percent or more market price decline from a recent high—a Roth conversion may provide unique benefits to certain individuals.

The Roth conversion opportunity is available to anyone that has a traditional IRA, regardless of income. The opportunity involves converting positions that have temporarily decreased in value due to the current economic conditions and paying the tax on the conversion in 2022. The tax should be paid from funds outside of the IRA to avoid shrinking the IRA balance and reducing the benefits of conversion. Once the account has been converted, it has the opportunity for tax-free growth.

For example, if an individual holds 500 shares of XYZ Company in a traditional IRA and plans to hold that investment for the foreseeable future, there may be a benefit to converting those shares to a Roth. The benefit works as follows:

Value
500 shares of XYZ at $334 per share on January 3, 2022 $ 167,000
500 shares of XYZ at $259 per share on June 23, 2022 $ 129,500
Decrease in value $   37,500

  Assuming a 35 percent blended federal and state tax rate, converting 500 shares of XYZ to a Roth IRA on June 23, 2022, would result in taxes of $45,325 ($129,500 @ 35 percent). This example assumes you have not made any nondeductible contributions to your traditional IRA.

Once the shares are converted to the Roth IRA and the account has been open for five years, any future distributions (after age 59 ½) are generally tax-free.

In this example, if XYZ appreciates to $357 per share, the taxpayer saves $17,150 of taxes, a 9.6 percent advantage. Obviously, if XYZ shares were to appreciate above $357 per share, the tax savings increases. On the flip side, if XYZ were to lose value then you may lose the advantage of converting.

The Roth conversion commonly referred to as a “backdoor Roth,” offers individuals powerful tax planning opportunities in retirement. Because Roth distributions are tax-free, retirees can better manage retirement distributions. This can be helpful in the event of unforeseen expenses such as medical costs or family emergencies. Instead of increasing taxable distributions in those situations, a tax-free Roth distribution can be used. Roth distributions can also assist taxpayers in avoiding the 3.8 percent tax surcharge on net investment income.

For the Roth conversion strategy to work, individuals should consider well-rated investments with prices that are down solely due to current economic circumstances. Investments such as penny stocks or digital currencies are probably not appropriate. Also, time will yield the largest returns. If one needs the funds in the near-term, there is no downside to converting to Roth, but the benefit may be limited.

Roth conversions present an interesting option for certain traditional IRA holders given the market downturn in 2022. For more information about Roth conversions contact R&A.

About this Author

John’s experience is concentrated in financial reporting and strategic planning for entities ranging from small and medium sized businesses to multi-national publicly traded companies.