Down Market Roth Conversions

[BryanMD]

I often see people on this forum saying that during market downturns they plan to use the opportunity to tax loss harvest and do Roth conversions. I get the TLH concept but can anyone better explain the Roth conversions? The reason I ask is that it seems like the posters that say this are also the members I would believe to be in the highest marginal tax bracket based on past posts. Is there an opportunity for people in the highest marginal tax bracket based on W2 or 1099 income to do Roth Conversions when the market drops?

[xraygoggles]

If you plan on doing Roth conversion anyways, doing it during a market dip is good because the amount you convert is essentially "buying low" in the Roth, and then when it eventually recovers, all the gains are being made in the Roth, with no future taxation on withdrawals.

As to why people in high tax brackets still convert, it's for tax diversification purposes in retirement.

[Lithium]

There is an argument that this is somehow different than market timing, but to me it is just another flavor of it. Sure, if the market drops 30% in a matter of weeks like it did last year, it’s hard to fault anyone for doing a major unplanned Roth conversion. But if your investing plan calls for doing Roth conversions, if you just sit around waiting for a major correction to do them, it could work out just as poorly as it would as if you held off on investing in cash 5 years ago because you were waiting to “buy the dip.”

[BryanMD]

So you are basically just buying low and getting a lower basis in an asset location where a low basis is fine because it won’t be taxed on withdrawal. But a downturn doesn’t inherently reduce the amount of tax you pay at the time of conversion correct?

When you do a Roth conversion, do you liquidate your funds and repurchase equivalent shares in the Roth, or are the same number of shares transferred in kind and you just pay the tax.

[GasFIRE]

So you are basically just buying low and getting a lower basis in an asset location where a low basis is fine because it won’t be taxed on withdrawal. But a downturn doesn’t inherently reduce the amount of tax you pay at the time of conversion correct?

When you do a Roth conversion, do you liquidate your funds and repurchase equivalent shares in the Roth, or are the same number of shares transferred in kind and you just pay the tax.

You are correct, the tax is based on the value of the assets at the time of conversion. If you plan to convert $1K to Roth and your tIRA is 100% VTSAX, you will convert more shares during a down market vs less shares in an up one. You can convert by liquidating then rebuying if you want to know the exact cash value on transfer but you may or may not be able to buy back the same number of shares. That will be determined by the market. You can also transfer-in-kind X number of shares with the value of the conversion determined when the transfer occurs. In the long run, the results will not be significantly different either way.

[jz-]

BryanMD,

be in the highest marginal tax bracket based on past posts.

you are correct, there is no strategic advantage to Roth conversions while in a high tax bracket.
We wait until low tax bracket years in early retirement to do these Roth conversions.

Your enthusiasm for financial literacy is impressive.

[Yowza]

BryanMD,

wait until low tax bracket years in early retirement to do these Roth conversions.

and besides, the market isn't really down that much

[JBME]

So you are basically just buying low and getting a lower basis in an asset location where a low basis is fine because it won’t be taxed on withdrawal. But a downturn doesn’t inherently reduce the amount of tax you pay at the time of conversion correct?

When you do a Roth conversion, do you liquidate your funds and repurchase equivalent shares in the Roth, or are the same number of shares transferred in kind and you just pay the tax.

I am someone who has done this a little bit. 24% bracket though. I do these as in-plan rollovers, as my 401k allows it. Due to this, the shares are just converted from the pre tax to the Roth bucket. No liquidation needed so same number of shares transferred.

[BryanMD]

BryanMD,

you are correct, there is no strategic advantage to Roth conversions while in a high tax bracket.
We wait until low tax bracket years in early retirement to do these Roth conversions.

Your enthusiasm for financial literacy is impressive.

I’m nothing if not enthusiastic.

[BryanMD]

and besides, the market isn't really down that much

I wasn’t planning to do any conversions anytime soon. Just trying to wrap my head around why it’s beneficial and who utilizes it during market drops.

Do people hoard some spending cash for the first few years of retirement to live off of to maximally drop their income and marginal tax rate?

[jz-]

BryanMD,

Do people hoard some spending cash for the first few years of retirement to live off of to maximally drop their income and marginal tax rate

Exactly. Planning for the early retirement years, we filled 3-5 bucket*years of cash-equivalents/bonds. aka. "bond tent"

[Tim]

“Do people hoard some spending cash for the first few years of retirement to live off of to maximally drop their income and marginal tax rate?”

planning your glide path and sequence of return risk. Most young focus (rightly) on accumulation. Planning is beginning to end. Happy reading. Yes you need cash available because a market. goes south when you need it.

[jfoxcpacfp]

There is an argument that this is somehow different than market timing, but to me it is just another flavor of it. Sure, if the market drops 30% in a matter of weeks like it did last year, it’s hard to fault anyone for doing a major unplanned Roth conversion. But if your investing plan calls for doing Roth conversions, if you just sit around waiting for a major correction to do them, it could work out just as poorly as it would as if you held off on investing in cash 5 years ago because you were waiting to “buy the dip.”

Not an argument, just common sense. Market timing is a guessing game on the “best” time to buy or sell. Converting when the market is down 20%+ is a known result. You are moving more savings to a Roth, knowing that it will come back in either the long or, sometimes short, term.

Roth Conversions 2 of 2: When and How to Convert - wrote it a few years back, but still relevant. You are taking advantage of a known (obvious) opportunity rather than guessing whether this is an opportunity. “I’m not buying in now because the market is at a top” or “I’m going to do a Roth conversion because I believe the market is undervalued” or “I’m selling everything because the market will only keep going down and I’ll lose what little I have left!” are 3 examples of market timing.

Personal example: When the market dropped precipitously due to COVID fears in March 2020, I did a significant Roth conversion and talked to other clients about it. That was not market timing, that was an opportunity. Even if the market had not recovered so quickly, even if the market had gone down another 10%, I still would have been happy I had converted - that didn’t change the fact that it was an opportunity to get more value into a Roth and, in effect, move at least part of the related taxes into the Roth. Now - if I had kept waiting for the market to bottom out before converting, that w/h/b market timing b/c I w/h/b guessing the short-term direction of the market.

When history tells us that a well-diversified, appropriately balanced mutual fund portfolio grows, on average 10% - 12% annually over the long term, it is, to me, blindingly obvious. What if history is wrong this time, you say? History is all we have to go by and it’s pretty solid, again impo, if you just stick with the basics and don’t massage them to suit your personal bias du jour. I’m certainly not making decisions based upon the “what if” crowd. I mean, sure, a tornado could swing through and level Mayfield again next year, but I’ll go with history and the odds that it won’t. I’m not going to move based on “what if”.

Of course, all of this means nothing if you don’t determine how much of your personal wealth you can invest based upon a solid financial plan that dictates what you need in the short term (the next 5 years) so you can set aside cash and bonds to meet those needs (proof that I do believe in using bonds). Everything else is for the long term. I see no need to purposely tamp down your returns with low-yielding cash and bonds simply because you don’t have a plan and have no clue what you’ll need when. Will the WCI crowd for the most part be perfectly safe either way? Yep. But that’s not the point.

[BryanMD]

When when you say “significant Roth conversion” what sort of amounts are we talking. What constitutes a big Roth Conversion?

[JBME]

Just like with Roth conversions in retirement, it makes sense to fill up your current bracket but not go into a higher one. This is why they are done best at the end of the year when you know your annual income. I did a conversion of $10k just over a week ago