Here we go again. I’m not talking about the Ray Charles country music standard that was popularized as a rhythm-and-blues duet with Norah Jones and earned them (posthumously for Charles) a Grammy Award for Record of the Year in 2004.
I’m referring instead to the recent thrashing of the stock market. With its drop of 358 points on Thursday followed by a loss of 531 points on Friday, the Dow Jones Industrial Average (DJIA) has fallen off 1,900 points, or 10.3%, since its high of 18,351 on May 19. The Dow hasn’t declined by more than 300 points for two consecutive sessions since Nov. 20, 2008, at the peak of the U.S. financial crisis.
Traditional Roth IRA conversion decision making focuses on current vs. future income-tax rates. Specifically, if your projected income-tax rate when you retire will be greater than what it is right now, you should consider doing a conversion. While this is an important consideration, there are seven problems with this advice:
- Very few people retire when they think they will.
- Income-tax rates have changed nine times since 1980.
- Income-tax rates will likely change several times in retirement.
- There will be unpredictable changes in income-tax laws independent of tax rates.
- Conducive income-tax scenarios that support a conversion. (See Considering a Roth IRA conversion before year-end?)
- The value of reduced annual required minimum distributions (RMDs) resulting from Roth IRA conversions.
- Absurd to avoid taxation on future appreciation of Roth IRA assets.
The last issue is the most glaring deficiency with traditional Roth IRA conversion decision making, in my opinion. An inordinate amount of time is too often spent on analyzing current vs. future income-tax rates instead of looking for favorable market conditions to do conversions. Given the unknown nature of future tax rates, too many people throw their hands up in the air and ultimately decide to keep their traditional IRAs and dormant qualified plans intact.
It isn’t about market timing
Whenever I’ve written articles or blog posts about this subject, I’m inevitably criticized for being a market timer. As my clients know, this couldn’t be further from the truth.
I’m not recommending that you ignore income-tax rates or that you try to time the market and wait for it to bottom out before you do a Roth IRA conversion. No one knows when this will happen. What I am advocating is that you keep your eyes open for situations where the stock market has declined 10% or more to determine if a conversion is worthwhile in your situation.
The bottom line is that it’s more prudent to do a conversion when the DJIA is 16,460 (Friday’s close) than 18,351 (May 19 high). To illustrate this, let’s assume that your traditional IRA portfolio mimics the DJIA; its value was $367,000 on May 19 and declined to $329,000 on Aug. 21; your combined federal and state income-tax rate, which is currently 35%, remains at this rate indefinitely; you do a Roth IRA conversion of $200,000; and you take withdrawals from your Roth IRA when the DJIA is above 18,500.
Your income-tax savings from doing your conversion when the DJIA is 16,460 vs. 18,351 would be $13,300, calculated as follows:
While this amount of savings may not seem significant to some, it’s important to keep in mind that it would be greater if the conversion is done when the DJIA is lower (think 6,547 on March 9, 2009, vs. 18,351 on May 19) and/or the conversion amount is larger. In addition, this doesn’t consider additional income-tax savings you may realize from reduced RMDs as a result of doing your conversion.
Your conversion can be insured
What happens if you do a Roth IRA conversion today and the stock market continues its downward trend? Will you incur tax liability based on the current taxable value of your conversion? Yes — unless you do a recharacterization.
A recharacterization is essentially a Roth IRA conversion insurance policy issued by the IRS. It allows you to undo your conversion, transferring the amount of your conversion plus earnings from your Roth IRA account back to your traditional IRA account via a trustee-to-trustee transfer. You have until April 15 following the year of your conversion or until Oct. 15 if your return is on extension.
The timing of a recharacterization can be tricky, assuming that your goal is to do another Roth IRA conversion of the recharacterized amount. IRS requires you to wait until the later of:
- 30 days after the recharacterization, or
- The year following the year of the conversion
Not the same opportunity as 2010
Individuals who did Roth IRA conversions in 2010 were spoiled. Not only was the stock market a lot lower, with the DJIA ranging between 9,614 and 11,625, you could also elect to defer taxation of the taxable portion of your conversion. If you did a conversion in 2010, you could spread your income tax liability over two years, reporting 50% of your conversion in 2011 and the other 50% in 2012.
Per the lyrics of the popular Don Henley song, Boys of Summer, “Don’t look back, you can never look back.” Whether or not you did a conversion in 2010, the current depressed stock market should be viewed as an opportunity for evaluating a partial or total Roth IRA conversion. You may not win a Grammy, however, there’s a good chance that you will increase the longevity of your retirement income by doing a conversion in the right circumstances.