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Retirement Weekly: Is now a good time for a Roth conversion?

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Now may be a good time to do a Roth conversion.

But, contrary to an argument that’s popular right now in financial planning circles, “the factors that make such a conversion a good or bad idea have nothing to do with the fact that the stock market is so much lower than where it stood at the beginning of the year.”

That’s according to Edward McQuarrie, a professor emeritus at the Leavey School of Business at Santa Clara University who has extensively analyzed the pros and cons of a Roth conversion. (A year ago, you may recall, I devoted two Retirement Weekly columns to his analysis—available here and here.)

In a Roth conversion, of course, you pay tax now on your IRA or 401(k) balances in order to avoid paying tax when you withdraw them down the road. With traditional—non-Roth—retirement accounts, in contrast, your portfolio compounds tax-free, but future withdrawals face a tax bill.

The reason so many financial planners are telling their clients that now is a good time for a Roth conversion: Because of the bear market, many if not most of their clients’ retirement accounts are sharply down. That means that converting those accounts to Roth status will incur a lower tax bill than would have been the case had the conversions been done in January.

This is a curious argument, however. To me, it’s akin to noting that a wing of your house burned down, so now you don’t have to spend as much to clean and maintain it.

It’s possible to construct hypothetical scenarios in which a Roth conversion made today will come out far ahead of one done this past January, McQuarrie told me in an interview. But the factors that determine these outcomes have little to do with the bear market, per se.

What are these assumptions that need to be made to justify a Roth conversion today? Here’s a summary of some of the major ones that McQuarrie mentioned:

You were otherwise planning on doing a Roth conversion in January of this year. This assumption is rarely acknowledged. Other things being equal, it is true that a Roth conversion done today would come out ahead of one done at the beginning of January. But so what? It’s also true that you would be even better off had you gone completely to cash rather than hold your shares of Netflix
NFLX,
+1.50%

(down 70% year to date), Facebook/Meta
META,
-1.68%

(down 52%), or ARK Innovation ETF
ARKK,
+2.05%

(down 55%). McQuarrie stresses that we need to put the past behind us, and focus on the future. “The fact that the S&P 500
SPX,
+0.50%

is down 20% from its all-time high is irrelevant to determining whether a Roth conversion will increase your after-tax wealth down the road.”

The stock market will quickly bounce back from the bear market. If the bear market is now ending, and will be back to new all-time highs within a few short months, as it did following the waterfall decline in early 2020, it becomes easier to justify a Roth conversion. But if the market drops another 20% between now and the eventual end of this bear market, which it entirely could, then a Roth conversion done at today’s prices should have been postponed until later. The implicit assumption made by financial planners who are urging a Roth conversion right now is that they have the ability to pinpoint market tops and bottoms. But if they had that ability, why didn’t they move your portfolio to cash in early January?

When you eventually withdraw funds from your retirement account, your tax rate may be higher than it is today. This is the major motivation for undertaking Roth conversions, of course. But what fewer financial planners acknowledge is that making an opportunistic Roth conversion might push your tax rate into a much higher bracket during the year of the conversion. This will especially be the case if you have a sizable IRA or 401(k). If you’re pushed into one of the higher brackets, chances are good that your tax rate in retirement will be lower. In that case, you should not do that Roth conversion now, even though stocks are way down and the taxes you would pay in a conversion today are much lower than if you had done it in January.

A dollar 20 years from now is just as valuable as a dollar today. This assumption is hardly ever acknowledged. But financial planners often justify a Roth conversion’s tax savings by comparing its tax bill to what you would have to pay when you eventually retire—in nominal terms. That’s a big no-no: A 2042 dollar is worth a lot less than a dollar today. This is especially important to acknowledge now, since the bear market has been caused by unexpectedly high inflation—which in turn increases the discount rate used to calculate present value. Imagine, for purposes of illustration, having a tax bill of $20,000 when doing a Roth conversion today, versus a total tax bill of $100,000 if you don’t convert and withdraw the funds beginning 20 years from now. In nominal terms this Roth conversion looks to be a no-brainer. But if we use the current inflation rate as the discount rate, then that future $100,000’s present value is less than $20,000—and a Roth conversion becomes a lot less compelling. McQuarrie also pointed out that tax brackets adjust for inflation each year, which is yet another reason why it will be much harder to be in a high tax bracket in 2042 when those withdrawals begin.

The bottom line? As is usually the case, the devil is in the details. Whether a Roth conversion makes sense for you individually depends on an objective assessment of those myriad details, along with realistic assumptions about future investment returns, your future tax rate, and your market timing abilities (or lack thereof).

But one thing is clear, according to McQuarrie: Nowhere among the details and assumptions you need to analyze will you find the fact that the stock market is down 20% since January.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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