Is it advantageous to convert a traditional IRA to a Roth IRA during a 50 percent market downturn?
If I have $20,000 in a Traditional IRA ($15,000 in contributions, $5,000 in gains), and the market plunges 50 percent, would I pay my income tax rate on $17,250 ($15K contributions + $2.5K gains) or $10,000 (current market value) if I choose to do a Roth conversion at that time? Is it advantageous to convert a Traditional IRA to a Roth IRA during a 50 percent market downturn?
Technically speaking, your answer is yes. It is advantageous given that you pay taxes on the converted amount, period. If the value drops, then you have less money to convert and less taxes to pay. I would look at the matter a little differently. I would look at preserving and protecting your portfolio from market downturns through proper asset allocation and diversification. You certainly can't diversify away all risk. But I would place my emphasis on being a smart investor first. I would address the conversion issue second by converting only the amount you would be comfortable paying taxes on. You can convert all or a portion of the IRA. You don't have to convert the whole account all in the same year. Convert what you can afford and leave the rest to be converted in later years. It's never wise to let taxes take precedence over being a smart, successful investor. If you follow my advice, you'll end up with the most money for retirement when you get there.
YES! You would only be taxed on the converted amount. Market timing is perilous, however. What if the market continues to fall another 20%, for example? Until 1/1/2018 Roth conversions could be "recharacterized" if this happened. That is, you could undo the conversion and then re-do it at the lower account value. No more.
Great question. Assuming your contributions were made on a "pre-tax" basis, the income you'd have to claim due to the conversion would be the value of the funds/investmets when they were converted. In your example, you would have to claim $10,000 in income from the conversion.
If you have available cash outside of the IRA with which to pay the income tax due, converting during a large market downturn is a great strategy. When the investments eventually recover, the gains will be tax-free!
Thanks for your question.
Your logic and math is correct. You would pay the tax on the converted amount in this situation. This is a strategy we often deploy during market corrections and one I think is a good idea. Also this tax environment is also quite favorable to Roth conversions. The coupling of the two would make for a unique environment it may take awhile to see again.
You would pay income tax on the declined market value of $10,000, if you choose to convert to a Roth IRA. Converting allows you to reposition your current tax-deferred Traditional IRA to a potentially tax free Roth IRA by paying federal and possible state income tax (but without the 10% IRS penalty tax) on the taxable amount of the conversion. Due to the lower balance in your Traditional IRA, the tax bill may be far less than it might be if you enjoy a period of positive market returns.