When the stock market crashes, most people freeze.
Today, David McKnight explains why a Roth conversion may be one of the smartest retirement moves you can make while prices are down.
Find out how to turn a market downturn into a chance to build tax-free income for the rest of your life.
-
In this episode, David McKnight asks whether a stock market crash is really a better time to do a Roth conversion.
-
Every time the market crashes, you hear the same advice from financial advisors: this is a great opportunity to do a Roth conversion.
-
The argument goes like this: if you have $1 million in your IRA and the market falls 30%, you can convert while it’s worth only $700,000, pay taxes on the lower value, and let the recovery happen inside your Roth IRA, tax-free.
-
Is a market crash really a better time to do a Roth conversion? David’s answer is “not really.”
-
To understand why, remember that your traditional IRA isn’t one pile of money but two piles commingled in the same account: your pile and the IRS’ pile.
-
If you have $1 million in your IRA and a 24% tax rate today and in retirement, $760,000 belongs to you and $240,000 belongs to the IRS.
-
When the market falls 30%, your share drops from $760,000 to $532,000, but the IRS’ share also drops from $240,000 to $168,000 – the IRS participates in the decline right alongside you.
-
So when someone says it’s a great time to convert because your tax bill just went down, they’re only telling you half the story: the bill is lower because the account you’re converting is worth less.
-
If you convert the $700,000 at the bottom at 24%, you’re effectively paying the IRS $168,000 to buy out its interest, leaving you with $532,000 after tax.
-
When the market recovers, that $532,000 grows proportionally back to $760,000, the same result you’d have gotten without converting.
-
David believes this is where much of the conventional advice about Roth conversions during crashes goes wrong: the market shouldn’t determine the tax bracket you’re willing to pay, your lifetime tax analysis should.
-
If you’ve concluded that 24% is an attractive rate and 32% isn’t, a 30% decline in the stock market doesn’t suddenly make 32% a good deal.
-
So you stick with your plan and still convert $200,000, filling the tax bracket you’ve already determined makes sense.
-
But something interesting has happened: if your IRA was worth $2 million before the decline, a $200,000 conversion was 10% of the account, and after a 30% drop to $1.4 million, that same conversion is more than 14%.
-
Same conversion, same taxable income, same tax bracket, but you’ve moved a substantially larger percentage of your remaining tax-deferred account to tax-free.
-
That’s the real opportunity: the market decline hasn’t created more wealth for you, your existing conversion strategy is now accomplishing more of its objective for the same amount of taxable income.
-
When the market falls, don’t say “let’s do a bigger Roth conversion”, say “let’s continue executing the strategy our financial plan already told us makes sense”.
-
And don’t do a Roth conversion you weren’t otherwise planning to do simply because stocks happen to be down.
-
Ultimately there are two completely separate decisions: at what tax rate are you willing to buy out the IRS, and how much of your IRA can you convert at that rate before tax rates go up for good?
-
The stock market doesn’t answer the first question, but a major market decline can affect the second.
-
Is converting your IRA during a market crash a mistake? No, but the crash shouldn’t determine whether you convert or what tax bracket you’re willing to pay.
Mentioned in this episode:
David’s newest USA Today bestselling book: The Secret Order of Millionaires: Seven Principles for Building Tax-Free Wealth
PowerOfZero.com (free video series)
