Down Market Investment Opportunities & Strategies – Roth Conversion
As the COVID-19 ‘Coronavirus’ pandemic has had an incredibly profound effect on the global markets, the global economy, and daily life in general, investors have witnessed their account balances drop at an unprecedented rate – an experience that can be incredibly stressful and emotional. While periods of uncertainty like this are challenging, there are several different opportunistic strategies that should be considered when portfolio values are low and, in this case, tax rates may be poised to move upward.
As the world grapples this pandemic, I’ll be releasing some blog posts to try to explain certain useful investment strategies and ideas. I’ll try to keep the topics as timely as possible, and I hope that I’ll be able to help some people in navigating these volatile markets.
The first strategy that I’ll discuss is the Roth Conversion.
Roth Conversion of Pre-Tax Savings
The current economic climate may lend itself to the opportunity to convert pre-tax savings (i.e. Pre-Tax 401k, Traditional IRA, etc.) to after-tax (or Roth) savings for two reasons: lower account balances and an enormously increasing tax deficit.
So, what is a Roth conversion?
A Roth Conversion can be described as the movement of money from a pre-tax account (401k, Traditional IRA, etc.) to a Roth IRA. You’ll owe income taxes on the money that you convert, but you’ll be able to take tax-free withdrawals when you tap into the account down the road.
Note: This strategy will increase your current year tax liability, and because so many jobs/businesses are on hold in an effort to slow the spread of the Coronavirus, paying a higher 2020 tax bill may not be a feasible strategy for those who have felt a major strain on their availability of cash.
Why to Convert During a Down Market
The COVID-19 pandemic has bruised the economy and pushed the markets downward, which has likely led to a decrease in the value of your investment accounts. If the value of your pre-tax retirement investment portfolio is down, paying taxes on these investments now in exchange for tax-free withdrawals in retirement may be a strategy that makes sense. Since the dollar value of the assets being converted is lower, you’ll be taking on less in taxable income than normal (i.e. if you convert an account that has decreased from $100k to $75k, you’ll be adding $25k less to your income to convert the account.)
From the perspective of a business owner, if your business is likely to suffer a Net Operating Loss for the year (you won’t be alone here), additional income resulting from a Roth Conversion can offset business-related losses.
Another Reason to Convert – Our Current Tax Climate
As you’ve likely heard in the news, the US Federal Government signed a stimulus bill to commit up to $2T in Coronavirus-related relief to American workers and businesses. The government will eventually attempt to make up for this debt by bringing in more revenue, which is likely to happen in the form of increased taxes. Converting to a Roth IRA is a method of paying income taxes on your investment account now, rather than after these speculative(!) tax increases. It’ll be important to monitor the upcoming 2020 Presidential Election to get an idea of how tax policies may be changed moving forward.
Converting a portion of your investment account to after-tax dollars is a good way to achieve tax diversification. Owning a combination of Traditional and Roth accounts gives you the option to tap into whichever you feel is most advantageous at the time. It should be a goal to pay taxes when your tax rates are relatively low, and to defer taxes when they are relatively high. The picture below illustrates this thought process:
Roth 401ks are an option that are becoming increasingly available for investors to utilize through their employer-sponsored retirement plans. One tip that many people aren’t aware of: if your employer offers a ‘company match’ on your contributions, you can elect to contribute on a Roth basis, and their match will automatically be allocated on a pre-tax, which can be a very convenient way to create some tax status diversification for your investments.
“It’s not about the cards you’re dealt, but how you play the hand.” -Randy Pausch
The Coronavirus pandemic was an unpredictable event that has abruptly pushed us outside of the normal circumstances that we’ve become accustomed to, otherwise known as a Black Swan Event. These events happen from time-to-time (i.e. the 2001 dot-com bubble, 9/11 terrorist attacks, 2009 financial crisis, etc.), and those who typically emerge from these situations in good shape are those who stick to their plan and ‘play the hand they’ve been dealt’. I hope that these blogs will help you develop a playbook of strategies that can be used during periods of market turmoil.
Hiring a team of trusted professionals with experience in this field can help to alleviate some of the pressure in making the inherently difficult decisions that come up along the way, allowing you to focus on your career and well-being. Now that many of us are participating in ‘Social Distancing’ and spending a great deal of time at home, having a discussion about Down Market Strategies & Opportunities with your Investment Advisor and/or Tax Accountant may be time well-spent.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
Traditional IRA and 401(k) account owners should consider the tax ramifications, age and income restrictions in regard to executing a conversion from a Traditional IRA or 401(k) to a Roth IRA or Roth 401(k). The converted amount is generally subject to income taxation.
The Roth IRA and 401(k) offer tax deferral on any earnings in the accounts. Withdrawals from the accounts may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to an account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs and Roth 401(k)s. Their tax treatment may change.