- The sudden spike in stock market volatility has led many individual investors to look for ways to de-risk their investment portfolios.
- A Roth IRA conversion is a powerful way to reduce the harm caused by a market correction.
- Such a conversion will significantly boost retirement benefits if the value of the IRA’s investments in the stock market recovers or tax rates rise after the conversion occurs.
“There are risks and costs to a program of action. But they are far less than the long-range risks and costs of comfortable inaction.”
-John F. Kennedy
The COVID 19 coronavirus has triggered a stock market correction of historic proportions. In the week just past, the Dow Jones Industrial Average and Standard and Poor’s 500 Index fell by 12% and 11%, respectively. At the same time, the VIX volatility index (the “fear index”) soared to just under 50, the highest since 2011. By the time the dust settled, the U.S. stock market lost more than $3 trillion in value, its worst weekly performance since the Great Recession.
The sudden spike in stock market volatility has led many individual investors to look for ways to de-risk their investment portfolios. The traditional way is to sell higher-risk assets (stocks) and reinvest the proceeds in lower-risk assets (bonds and cash).
There are significant drawbacks to the conventional approach to de-risking investment portfolios. They include the potential for a market to spring back and the triggering of capital-gain taxes. Numerous studies have demonstrated time and again that these drawbacks often outweigh the potential benefits of changing asset class allocations.
A Roth IRA conversion is an unconventional way to reduce the harm caused by a market correction. A Roth IRA is a special type of IRA that is funded with after-tax contributions. While contributions to a Roth IRA are taxable, distributions from a Roth IRA (whether to you or your designated beneficiary) are not. In other words, while tax on the earnings of a traditional IRA are deferred until those earnings are distributed, the income earned on a Roth IRA’s investments is never taxed.
An existing traditional IRA can be converted to a Roth IRA. Such a conversion can significantly boost retirement benefits if the value of the IRA’s investments appreciate more rapidly after the conversion occurs and/or income tax rates increase after the conversion occurs. Right now, there is good reason to believe both of these could occur, making it an ideal time to consider a Roth IRA conversion.
If history can be counted on as our guide, the stock market will enjoy a strong recovery when the COVID-19 scare is over. On average, it has taken the market about four months to recover from the 26 corrections that have occurred since World War II. Therefore, it is reasonable to expect the stock market will enjoy above average rates of growth in the months ahead, assuming the coronavirus does not trigger a global financial crisis.
In addition, income tax rates are currently scheduled to increase in 2026 when many rate cuts made by the Tax Cuts and Jobs Act of 2018 expire. Moreover, depending on the outcome of the upcoming elections, tax rates could rise more quickly and/or move higher than currently provided by the Internal Revenue Code.
Another advantage to instituting a Roth IRA conversion now is that the tax triggered by the conversion will be deferred until 2020 taxes are due. That means the markets will have quite a bit of time to recover from the coronavirus scare before you will need to raise the cash to pay the tax. Tip: When that time comes, keep in mind that a Roth IRA conversion is better still when funds outside the IRA are used to pay the tax due on the rollover.
Lastly, if you decide to convert, keep in mind that converting to a Roth IRA gradually over several years (a “staged Roth conversion”) can help you avoid being pushed into higher tax brackets in the conversion years. Then again, a gradual conversion could backfire if tax rates are raised sooner, or the portfolio appreciates faster, than expected.
Thank you for reading,
Mr. Market Commentator
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