The first eight months of 2022 have been tough for investors. Stock indexes around the world have declined by double digits, while historically safe bonds have suffered their worst performance in decades. Eventually, markets will resume their upward trend, but unfortunately, no one knows exactly when that time will come, and furthermore, no one can control the market or its direction.
That’s why at times like these, you might want to remember the old adage:
When life gives you lemons, make lemonade
How Does “Tax-Free” Sound?
The key to a successful retirement is to generate a paycheck from your portfolio, and the more tax efficiently you can do so, the longer your money will last or the more you can spend. One of the most effective tools for generating future income without taxes is a Roth account. Roth accounts are retirement accounts, but unlike traditional, pre-tax IRAs and 401(k)s, the money you deposit into a Roth does not give you a tax deduction in the current year. That’s the bad news.
The good news, and the reason Roth accounts can be so powerful for future income planning, is that the dollars you pull out of a Roth are free from taxes. The ability to generate tax-free income in retirement gives you more control over your future tax brackets, protection against future tax rate hikes, and a hedge against future inflation.
Sounds pretty good, right?
What is a Roth Conversion?
There are two main ways to get money into Roth accounts: contributions and conversions.
Contributions, as the name implies, are when you make an initial deposit of dollars from your paycheck or savings account into a Roth account. A Roth conversion is when you move dollars from an existing pre-tax retirement account and transfer them into a Roth account.
Keep in mind that dollars in a pre-tax account have never been taxed, and any time those dollars leave that account, you’ll pay taxes. So, when you process a Roth conversion and move dollars from a pre-tax to a tax-free [Roth] account, you’ll pay taxes on the amount you convert. That’s the bad news.
The good news is that you were always going to pay taxes on those dollars when they leave your account, regardless of timing, and by processing the conversion, you’ve taken control of:
- When you pay those taxes
- What tax rate you pay
Furthermore, all future growth on those dollars you’ve converted is now free from tax. Think of it like paying taxes on the seeds, not the harvest.
How a Down Market Helps
Let’s get back to the idea of making the most out of a tough market. If you’ve been considering Roth conversions anyways, doing them in a down market carries two advantages.
First, you can convert either cash or securities. Let’s say you convert securities, and you have 100 shares of Microsoft. Nine months ago, the stock was trading at around $340 a share, and today it is trading at around $290 a share.
- Scenario 1: You converted 100 shares of Microsoft nine months ago. You now have 100 shares in your Roth account, but you also generated $34,000 in taxable income.
- Scenario 2: You convert 100 shares of Microsoft today. You now have 100 shares in your Roth account, but you only generated $29,000 in taxable income.
The bottom line is that if you convert when the market is down, you can move the same number of shares for a smaller tax hit.
The second major benefit of converting in a down market is that, all else being equal, future market performance tends to be better from lower starting levels. And since all future growth in your Roth account is free from taxes, the greater the returns, the greater the benefits from a conversion.
So, there you have it: Lemonade out of lemons. Market declines can be painful, but by focusing on factors within your control, you can position yourself to benefit from future bull markets. And even better, by utilizing savvy tax planning today, you can improve your odds of a successful retirement.