Should I do a Roth IRA conversion when the market is down?

Investors have experienced a lot of uncertainty the past few years. Soaring inflation and unease over the economy sent stocks reeling, leaving depressed retirement account balances in their wake. However, amid an ever-fluctuating market, there's this: You could be saving a lot of money on your tax bill if you choose to perform a Roth IRA conversion, whether the market is down or not. Find out why that's the case and whether converting your account is right for your long-term objectives.

A Roth IRA conversion involves taking money or securities from a tax-deferred retirement account such as a traditional IRA or 401(k)—where you typically contribute pre-tax dollars—and putting them into a Roth IRA.

Unlike traditional retirement accounts, you can't claim an income tax deduction on the money you contribute to a Roth IRA. However, they hold a different tax benefit. Your money grows on a tax-deferred basis and you can make completely tax-free withdrawals in retirement; to do so, you have to be at least 59½ and have owned the account for at least five years.^1,2

For workers who anticipate being in a higher tax bracket later in life, that switch can be a smart financial strategy. However, you do have to pay income tax on any pre-tax contributions that you convert, so you may need a significant cash reserve to pull it off.

While market downturns feel gut-wrenching for investors, they may be the perfect time to convert your pre-tax contributions to a Roth IRA. Why? You'll be paying income tax on a smaller portfolio balance.

Let's say you have a traditional IRA that was valued at $100,000 at the beginning of the year. At that point, you would've had to pay income tax on that entire $100,000 if you wanted to convert to a Roth IRA. But let's assume, given sliding stock prices, that your account balance drops to $80,000. Now you're paying income tax to convert that smaller amount. That could equal some big savings.

Of course, depending on the size of your savings and your tax rate, a conversion can still trigger a hefty tax bill and count toward your gross income for that year. A financial advisor or tax professional can help you estimate how much tax you'll need to pay on the conversion. While Thrivent does not provide specific legal or tax advice, we can partner with you and your tax professional or attorney.

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Paying taxes now in exchange for tax-free withdrawals in retirement may be advantageous for some investors but not others.

• You expect your income to rise. Obviously, you'd rather pay income taxes when you're facing the lowest-possible tax rate. If you feel that your peak earning years are still ahead of you or you simply want tax diversification, converting some or all of your retirement assets now could be a wise move.

• You're concerned about taxes increasing. The Tax Cuts and Jobs Act of 2017 lowered marginal tax rates but only temporarily. Without additional legislation, they'll revert to the higher, pre-TCJA rates in 2026. If that does come to pass, you may be better off paying tax at today's rates.

• You want to avoid RMDs. Workplace plans and traditional IRAs come with required minimum distributions (RMDs) that you have to start taking at a specific age. Roth IRAs, on the other hand, don't have RMDs. So if you don't anticipate having to lean on your retirement account for income, a Roth IRA potentially allows you to leave more assets for your heirs.

• You have the money to cover the taxes. Performing a Roth conversion during a bear market may have its benefits, but you nonetheless might be stuck with a large tax bill. Pulling assets out of your retirement plan, or electing tax withholding to pay the tax, will trigger a 10% early withdrawal penalty on the amount held if you are under 59½, so you'll need cash on hand to cover your liability.^1,2,3

That said, converting money to a Roth IRA account may not be right for everyone. Since 2018, you're no longer allowed to "recharacterize" your Roth conversion, which is essentially like "unconverting" your conversion. So, if you elect a Roth conversion as part of your long-term strategy, you want to be absolutely certain that it's in your best interest. The money you convert counts as taxable income for the year, so you'll want to make sure it doesn't push you into a higher bracket.

Additionally, keep in mind that unlike money you invest directly into a Roth IRA (not through a conversion), you can't immediately access your contributions tax-free. The funds have to be in your account for at least five years; otherwise, you'll face the 10% early withdrawal penalty.¹ You may also want to tread carefully if you're a retiree and a distribution would affect your Medicare premiums or affect the tax treatment of your Social Security benefits.

In theory, the ideal time to convert at least part of your qualified employer-sponsored retirement accounts to a Roth IRA is when the market is at its absolute low point. Unfortunately, though, no one knows when major indexes like the S&P 500 will actually bottom out before climbing back up.

For that reason, many experts recommend breaking up your conversions into smaller distributions. That means if you plan to convert your entire traditional IRA to a Roth IRA, perhaps you can convert half of that amount now and the rest closer to December. Conversely, you can break it up into monthly or quarterly conversions. If the market continues to drop throughout the year, you could end up paying tax on a smaller portfolio balance (and vice versa).

There's no IRS limit on the number of conversions you can perform in a year, so the only impediment to breaking it up is the extra paperwork and time. Your financial advisor can help you develop a strategy that helps you manage market volatility and minimize taxes in the current year.

Splitting up your Roth conversion in this way has at least two main advantages.

• If the market drops further, you're paying tax on shares that are worth less than they were early in the year.

• It allows you to fine-tune your tax planning. Say you receive a bonus in December and any additional retirement distribution would push you into a higher bracket. By doing your conversion gradually, you can hold off on that last planned distribution of the year in order to keep your tax liability in check.

Undoubtedly, choosing if, when and how to perform a Roth IRA conversion involves a lot of factors. Collaborating with a local Thrivent financial advisor can help you weigh the pros and cons, keep an eye on the market and create a conversion strategy that best serves your financial needs.