Should a high income professional convert pre-tax retirement accounts to a Roth IRA and pay the taxes in peak earning years? The answer may seem obvious to some, but this is actually a difficult question. Lacking a crystal ball, we must make decisions with the information available to us. Here are the unknowns you need to consider:
- Will I be in a lower tax bracket when I retire?
- Will I be able to afford to pay the taxes on a conversion when I retire with a low income or should I pay while I can afford to?
- How much growth can I expect if I convert now?
- What if I convert and then can’t afford the tax bill?
- Will the IRS continue the favorable tax treatment of Roth IRAs when I retire?
You may be planning to wait until retirement to begin converting your IRAs to Roth IRAs because you “expect” to be in a lower tax bracket (or because inertia is so much easier…), but you’re ignoring volatility in the market. If you are in an extended bull market at retirement, it’s going to be difficult to talk yourself into paying taxes at peak values.
While bear markets (defined as a sustained dip of 20%+ in the S&P 500) are unpredictable, they occur, on average, about every 5.5 years. This affords you a golden opportunity to permanently bump up the value of your portfolio. Of course, this doesn’t mean you can circle the date of the next bear or correction on your calendar, but you can be prepared to make the most of periodic declines.
So how do you capitalize on a sharp decline in your portfolio when your senses are screaming “It’s the end! My retirement is doomed!” ? It’s quite possible. Let’s look at an example:
- Assume you converted a $250,000 IRA to a Roth in an S&P 500 index fund in January 2009, during the last bear market.
- We’ll also assume the conversion pushed you into the 39.6% tax bracket. Let’s round your marginal tax bracket to 50% to reflect state/local taxes and other effects of the higher bracket. This would yield a tax bill of $125,000 on the conversion.
- As of August 2016, the Roth would have been worth $683,678.24 (dividends reinvested). Source: Investing Through Time.
What does this mean? In effect, you moved the $125k taxes you paid on your conversion into the Roth IRA which grew another $308,678.24 tax-free in the next 7.5 years for a total return of 247% on your investment of $125k. All things being equal, wouldn’t you rather have that post-bear market growth inside a Roth IRA rather than in a pre-tax retirement account?
To benefit the most from this strategy, you should hold an appropriately-diversified equity mutual fund/ETF portfolio for all long-term investment portfolios (long-term meaning you won’t need to touch your account for 5+ years). You should also have enough liquidity on hand to pay the tax bill that will arrive the next April – or at least be able to get your hands on the money without negatively impacting your tax-advantaged account.
For example, I would never recommend selling other investments just to fund your taxes due. However, I would recommend setting up a savings account earmarked to pay conversion taxes when the opportunity arises!
So I bet I can guess what you’re thinking: what if the market doesn’t come back after a bear market? Remember, all we can base a plan on is the information available to us. Since 1926, equities have returned 10% – 12% annually with dividends reinvested. This assumes a well-diversified portfolio which should be rebalanced annually.
Since 1926, the average bull market has lasted 8.9 years but the average bear market has lasted only 1.3 years. Most important, though, is how the market behaves after a bear – it has always come roaring back. We all know that the “time to buy is when there’s blood in the streets” (Rothschild) – how much better to invest in a Roth IRA when everyone else is selling?
By the way, markets also “correct”, on average, around 14.1% on an intra-year basis. Use these market dips to convert chunks of IRAs to Roth IRAs by filling out your marginal tax bracket. This is the same theory as above but integrated with intra-year tax strategizing.
So what if you convert and then can’t afford the tax bill or simply change your mind? As I mentioned in part 1 of this series, the IRS gives you until the due date of your income tax return, including extensions, to recharacterize your Roth conversion.
It’s like a mulligan for Roth conversions! In the above example, you had until October 15, 2010, a full 21.5 months, to use that mulligan for all or part of your conversion. This makes converting to a Roth during bear markets and corrections the best financial no-brainer that I can come up with.