By Robert Klein, CPA
As I write this article, the S&P 500 dropped 917 points, or 19%, in less than four and a half months from its high of 4,819 on January 4th to a low of 3,901 on May 20th before closing at 4,158 on May 27th. The NASDAQ plummeted 5,085 points, or 31.5%, from its high of 16,121 on November 19, 2021 to a low of 11,036 on May 20th before closing at 12,131 on May 27th.
A bear market occurs when an index has fallen 20% or more from a recent high for a sustained period of time. The NASDAQ has been in a bear market, with the S&P 500 teetering on the edge.
Staged Roth IRA Conversion Window of Opportunity
In my role as a retirement income planner, I’m always looking for windows of opportunity for my clients to leverage and protect their assets to optimize their projected after-tax retirement income. One of those windows of opportunity that has proven to be a successful part of many of my clients’ retirement income plans is the use of a staged Roth IRA conversion plan during market downturns, especially in bear markets.
A staged Roth IRA conversion plan is a strategic multi-year plan that’s used to optimize the projected longevity of one’s assets as part of a holistic retirement income plan. The purpose of using a multi-year approach is to minimize income tax liability associated with Roth IRA conversions while taking advantage of market downturns whenever possible. The low federal income tax rates that are scheduled to expire after 2025 and could occur sooner provide an opportunity to minimize income tax liability when doing Roth IRA conversions.
Eliminate Taxation on the Growth of Converted Assets
The primary purpose of doing a Roth IRA conversion is to eliminate taxation on the growth of converted assets. Although Roth IRA conversions result in taxation of the value of converted amounts to the extent that they exceed basis, 100% of the value of Roth IRA assets, including appreciation, is exempt from taxation. Appreciation is typically responsible for the majority of the value of retirement plan assets over time.
As an example, suppose you did a Roth IRA conversion of $100,000 in an S&P 500 index on March 23, 2020 when the index closed at 2,237. This was the bottom of the most recent bear market for the S&P 500 when the index fell 34% in the one-month period that began on February 19, 2020.
Let’s fast forward. Even though the S&P 500 has declined 14% from its high of 4,819 on January 4th to its May 27th closing price of 4,158, it has appreciated 1,921 points, or 86%, since you did your hypothetical Roth IRA conversion on March 23, 2020. Your Roth IRA would currently be worth $186,000 with unrealized appreciation of $86,000 permanently exempt from taxation.
Why Implement a Staged Roth IRA Conversion Plan?
The motivation for implementing a staged Roth IRA conversion plan is simple. If you invest in taxable retirement plans such as traditional 401(k)s, SEP-IRAs, and traditional IRAs, the good news is that you receive a tax deduction for your contributions and your assets grow tax-deferred so long as they remain in your various plans.
The bad news is that 100% of the contributions you make to your plan and the appreciation will be subject to taxation from the moment you begin taking distributions until all assets have been withdrawn from your plans by you, your spouse, and potentially other beneficiaries. Once again, appreciation is typically responsible for the majority of the value of retirement plan assets over time.
If you don’t do strategic Roth IRA conversions, the amount of income tax liability attributable to your distributions can exceed the tax liability you would incur with a staged Roth IRA conversion plan. This translates to less spendable income in your retirement years and potential depletion of investment assets sooner than would otherwise occur. The likelihood of this happening increases to the extent that you don’t reinvest the income tax savings from deductible contributions to your traditional 401(k), SEP-IRA, or traditional IRA plans, which is often the case.
Other Benefits of a Staged Roth IRA Conversion Plan
In addition to permanently eliminating taxation on the growth of converted assets, a staged Roth IRA conversion plan offers the following five benefits that are discussed in 7 Reasons to Start a Staged Roth IRA Conversion Plan Today and 6 Proven Retirement Income Planning Strategies Beginning at Age 62:
- Reduce required minimum distributions beginning at age 72
- Potentially reduce Medicare Part B and D premiums
- Reduce widow or widower’s income tax liability
- Reduce dependency on taxable assets in retirement
- Reduce taxable income for non-spouse beneficiaries
Each of the above benefits can individually and collectively extend the life of after-tax assets of their owners and beneficiaries.
Should You Wait for the Stock Market to Decline Further to Do a Staged Roth IRA Conversion Plan?
Although the S&P 500 and NASDAQ have declined approximately 20% and 30%, respectively, from their recent highs, a common question is, “Should I wait longer to do a Roth IRA conversion since the stock market could decline further?”
One of the benefits of a staged Roth IRA conversion plan is that Roth IRA conversions are done in stages at opportune times. A decline of 15% to 20% in the value of a retirement plan is an opportune time to do a Roth IRA conversion.
The goal should never be to try to time the market. The nature of a staged Roth IRA conversion is such that you can do multiple Roth IRA conversions within a particular year if the value of your taxable retirement plan decreases after you do your initial conversion.
The Current Roth IRA Conversion Window of Opportunity Won’t Last Forever
A market downturn, especially a bear market, is always painful when you’re going through it. Like any storm, however, it won’t last forever. This was demonstrated in the example when the S&P 500 Index declined 34% in one month beginning on February 19, 2020 due to the COVID-19 pandemic after which global stock markets returned to a bull market in April 2020.
Given the fact that staged Roth IRA conversion plans are proven to extend the life of after-tax retirement plan income and assets in many cases, low federal tax rates are scheduled to expire after 2025 and could occur sooner, and it’s generally prudent to spread Roth IRA conversions over several years, the current Roth IRA conversion window of opportunity should be on every taxable retirement plan participant or owner’s radar.
If you’re in your 40s, 50s, or 60s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs, why wait until age 72 when the value of your plans has potentially doubled or tripled and tax rates are likely to be higher to begin to pay tax on inflated distributions? Wouldn’t you rather use prudent tax-sensitive retirement income planning strategies today to pay less tax for the rest of your life and have more funds available when you need them the most, i.e., during your retirement years?
About the author – Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. The firm’s motto is Planning, Managing, and Protecting Your Retirement Income™. Bob is the creator of FINANCIALLY InKLEIN’d™, a YouTube channel featuring tax-sensitive, innovative strategies for optimizing retirement income. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob began in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including fixed income annuities, Roth IRA conversions, HECM reverse mortgages, and charitable remainder trusts, to optimize the projected longevity of his clients’ after-tax retirement income and assets. Bob does this as an independent financial advisor using customized holis
tic planning solutions determined by each client’s financial needs.