The Market Downturn Discount for Roth Conversions
Investors have been struggling with market volatility for months—and for many, the uncertain market conditions have also been unsettling. When the market turns south, clients inevitably start calling for advice about tax-smart moves that can help them make the most of the market downturn. In the wake of market uncertainty, it's important to remember that opportunities exist. That's especially true when it comes to developing tax-smart retirement planning strategies using Roth retirement accounts. Roth conversions are one of the most valuable tax planning moves a client can make during a market downturn. While it can be difficult to identify anything positive about depressed asset values, lower asset values actually serve to reduce the cost of Roth conversions—increasing the appeal of the strategy for many savvy retirement investors.
Roth Conversions and Depressed Asset Values
Roth IRAs 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 a retirement investor converts 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 Because the account owner pays taxes on the funds today, those funds (and, in most cases, any earnings) can be withdrawn tax-free in the future.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 retirement investments has declined (which has been the case for many investors in recent months), the investor can convert the IRA 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.
Under current law, conversions may be even more attractive to certain clients because the lower income tax rates put into place in 2018 have been made permanent by the One Big Beautiful Bill Act—and clients should be advised that nothing is ever really permanent when it comes to the Internal Revenue Code.
Additional Considerations
There are many additional considerations when determining whether now is the time to execute a Roth conversion—in other words, a market downturn doesn't automatically mean that it's the best time for any given investor to execute a 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 always consider whether they anticipate having cash on hand to cover the tax bill (preferably, with non-retirement funds). Selling investments in a down market to cover the tax bill can be counterproductive, locking in some of the investment losses for the investor.
Investors should also consider ancillary consequences that can stem from a Roth conversion. 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 IRMAA increases Medicare premiums (in stages) 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. Despite the currently-lower rates, investors should be aware of their specific tax bracket. Converting in stages is always an option. The individual can decide to convert just enough to reach the top of their current income tax bracket without jumping into a higher tax bracket. It can also be beneficial to convert during a low-tax year, where the individual has less income when compared to prior years (and anticipates a future increase in income).
Additionally, it's important to remember that taxpayers can no longer recharacterize (or undo) 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 reform eliminated this benefit.
Conclusion
Anytime a client is considering a planning move, it's critical to evaluate their specific financial position and goals in addition to market conditions. In today's volatile market, reduced asset values can make a Roth conversion more appealing—but it's always important to consider the entire picture. Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.