Should You Do a Roth Conversion When the Market is Down?

A Roth conversion is the process of moving funds from a pre-tax retirement account, such as a Traditional IRA or a former employer’s 401(k), into a post-tax Roth IRA. This transaction requires you to pay ordinary income tax on the amount you convert in the year the conversion takes place. The primary benefit is that once the funds are in the Roth IRA, they can grow and be withdrawn in retirement completely tax-free, provided certain conditions are met. Market downturns can present an opportunity for this financial maneuver, as executing a conversion when investment values are temporarily depressed can lead to a lower tax bill.

The Financial Advantage of a Downturn Conversion

The benefit of converting to a Roth IRA during a market downturn is a lower tax liability. The income tax you owe is based on the market value of the assets at the time of the move. When markets fall, the value of your portfolio decreases, meaning the taxable amount of the conversion is also lower, allowing you to move more shares for the same tax cost.

For example, if you have an investment in a Traditional IRA valued at $50,000, converting it would add $50,000 to your taxable income. Assuming a 24% federal tax rate, this results in a tax bill of $12,000. If a market correction causes the value to drop to $30,000, converting at this point adds only $30,000 to your income, for a tax bill of $7,200.

The advantage becomes more apparent when the market recovers. The $30,000 of converted assets are now inside a Roth IRA. As the market rebounds to the original $50,000 value, that $20,000 gain occurs within the Roth account. All of that recovery and subsequent growth will be tax-free upon withdrawal in retirement.

This strategy is effective for in-kind conversions, where you move the actual investment shares rather than selling them for cash first. By transferring the depressed shares directly, you capture the full upside of the recovery within the tax-free Roth environment.

Calculating the Conversion Tax Liability

The amount you convert from a traditional retirement account to a Roth IRA is added to your ordinary income for that tax year. This increase can push you into a higher marginal tax bracket. For instance, an individual with $150,000 of taxable income is in the 24% bracket; converting $50,000 would raise their income to $200,000, pushing a portion of that income into the 32% bracket. This elevation of Adjusted Gross Income (AGI) can also reduce or eliminate your eligibility for certain tax deductions and credits.

A component in calculating the tax is the pro-rata rule, which applies if you have made both pre-tax and after-tax contributions to any of your traditional IRAs. The IRS requires you to aggregate all Traditional, SEP, and SIMPLE IRAs as if they were one account to determine the taxability of a conversion. You cannot choose to convert only the after-tax money; each converted dollar is deemed to contain a proportional mix of pre-tax and after-tax funds.

To illustrate, imagine you have $100,000 across all your traditional IRAs. Of this total, $80,000 is from pre-tax funds and $20,000 is from after-tax contributions, meaning 20% of your balance is after-tax money. If you convert $50,000 to a Roth IRA, the pro-rata rule dictates that 20% of that conversion ($10,000) is a tax-free return of your after-tax contributions.

The remaining 80% of the conversion, or $40,000, is pre-tax money and must be included in your taxable income. This calculation is performed using IRS Form 8606, Nondeductible IRAs, which must be filed with your tax return. The form is used to report the conversion and prevent individuals from isolating non-deductible contributions for a tax-free conversion.

Information and Decisions Prior to Conversion

Before initiating a Roth conversion, several decisions must be made.

Choosing Which Assets to Convert

The first step is selecting which account to convert from. You can convert funds from a Traditional IRA, SEP IRA, SIMPLE IRA (after a two-year waiting period), or a pre-tax 401(k), 403(b), or governmental 457(b) from a former employer. The choice may depend on the investment options within each account.

A market downturn provides an opportunity to be selective, choosing to convert only those assets that are significantly undervalued. This targeted approach allows you to focus on investments you believe have the strongest potential to rebound. There is no limit on the number of partial conversions you can perform in a year.

Paying the Conversion Tax

You must decide how to pay the income tax due on the conversion. The preferred method is to use funds from a separate, non-retirement account, such as savings or brokerage. This allows the full converted amount to be moved into the Roth IRA to grow tax-free.

If you choose to have taxes withheld directly from the converted amount, those withheld funds are considered a distribution. If you are under age 59 ½, that distributed portion could be subject to a 10% early withdrawal penalty in addition to income tax.

The Five-Year Holding Period

All converted funds are subject to a five-year holding period. Each conversion has its own five-year clock, and if you withdraw the converted principal before that period is over, it may trigger a 10% penalty, even if you are over age 59 ½. The five-year period for each conversion begins on January 1 of the year the conversion was made.

Required Minimum Distributions (RMDs)

You must determine if you are subject to a Required Minimum Distribution (RMD) for the year. IRS rules mandate that you satisfy your annual RMD from your IRAs before you can convert any funds from those accounts. The RMD amount itself cannot be converted to a Roth IRA.

The Roth Conversion Process

To execute a Roth conversion, you will need to contact the financial institution that holds your traditional retirement account to initiate the transfer. Most brokerages allow this to be done online, over the phone, or by completing a conversion form.

You have two options for how the assets are moved: an in-kind transfer or a liquidation and cash transfer. An in-kind transfer moves your existing investments directly from the traditional account to the Roth account without selling them. This is often preferred during a market downturn as it keeps you invested, ensuring you don’t miss a market rebound.

The alternative is to sell the assets in the traditional account and then move the resulting cash to the Roth account, where you would then repurchase investments. After you initiate the conversion, your financial institution will handle the transfer of assets and send a confirmation once the transaction is complete.

Early in the following year, you will receive Form 1099-R from your financial institution, which reports the total amount distributed from your traditional account. You must then report the conversion on your federal tax return using the information from this form and the calculations from Form 8606.