Why Clients Should Consider Roth Conversions When Stocks Drop

As always, it's important to consider the specific picture for each client.

Roth Conversions and Depressed Asset Values

Roth individual retirement accounts and Roth 401(k)s are funded with after-tax dollars — unlike their traditional counterparts, which are funded with pre-tax dollars to create an immediate tax benefit. When investors convert traditional retirement account funds to a Roth, they pay taxes on the value of the converted assets in the year of conversion. Because the account owner pays taxes on the funds today, those funds (and, in most cases, any earnings) can be withdrawn tax-free in the future.

The primary reason to consider moving traditional retirement funds into a Roth account in a market downturn is that the associated tax liability is reduced when compared to strong market conditions.

If the value of the investments has declined, the investor can convert assets at that lower value and benefit from a correspondingly lower tax liability. They can, essentially, move more investment shares into the Roth at the same tax cost. When the market rebounds, the gain on the converted Roth assets will be tax-free to the investor, because that rebound has occurred within the Roth structure.

Conversions may be even more attractive to some clients because the lower income tax rates put into place in 2018 have been made permanent by last summer's tax and spending megabill. Of course, clients should be advised that nothing is ever permanent when it comes to the Internal Revenue Code.

Additional Considerations

A market downturn doesn't automatically mean that it's the best time for any given investor to execute a Roth conversion.

The growth on the converted amount is not taxed when the investor later withdraws the funds. However, the client will have to pay tax on the current conversion (for 2026 conversions, that tax bill will be due by April 15, 2027). Investors should consider whether they anticipate having cash on hand to cover the tax bill. Selling investments in a down market to cover the tax bill can be counterproductive, locking in some of the investment losses.

Since the amounts converted are treated as taxable income in the year of conversion, increases in taxable income can trigger the Medicare income-related monthly adjustment amount, or IRMAA. The surchage increases Medicare premiums for beneficiaries once their income reaches $109,000 ($218,000 for joint filers).

In all cases, taxpayers should consider their tax rates when executing a Roth conversion. They can decide to convert just enough to reach the top of their current income tax bracket without jumping into a higher bracket. It can also be beneficial to convert during a low-tax year, where the individual has less income when compared to prior years.

Additionally, taxpayers can no longer recharacterize a Roth conversion. Under pre-2018 law, investors could use the benefit of hindsight and undo the conversion if the market did not perform as expected. The 2017 tax overhaul eliminated this option.

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