As a general rule of thumb for investors who can assume their tax bill will be the same now as it is after retirement, the tax on a Roth conversion will be proportionately less during the downturn, said Jame G. Blase, a tax attorney, advisor and principal of the law firm Blase & Associates LLC in Chesterfield, Mo.
If the market decline is 20%, for example, the tax to convert “an $80 gain will generally be 20% less than the tax on a $100 gain,” Blase said. “One thing to bear in mind, however, is that we cannot just assume the market will not go even lower for a period of time, in which case the investor may end up overpaying by converting now.”
Retired clients, whose tax brackets are not likely to go lower in the future, are generally the best candidates for conversions, he said.
“If the investor is currently working, and therefore in a higher income tax bracket than he or she may be after retirement, this may not necessarily be a good time to convert,” Blase added.
The tax bracket difference between working people and retired people should be a main consideration that some advisors miss, he said.
Advisors “who preach that tax brackets are going to rise in the future, so therefore now is the right time to do Roth conversions, are generalizing. I never advise working clients to do any significant Roth conversions,” Blase added.
Hratch J Karakachian, a CPA and tax attorney in Glendale, Calif., said market downturns can shave the tax bill for Roth conversions significantly for the right investors. “It’s a really good little downturn we’re in right now and that can help,” he said.
The California tax attorney said that based on his calculations, if a client owned a $100,000 portfolio that declined 30% to $70,000 and the client’s combined federal and state tax bracket is around 33%, he or she could save about $7,000 doing the Roth conversion.
“The tax on their conversion before [the market decline] would have been about $30,000 and it decreases to $21,000 after. The hope and goal is for the position to go back up, so that the tax is offset and gains are tax-free,” Karakachian said.
He said it’s important, however, to remind investors that they don’t have to sell assets to do a Roth conversion and that once done, Roth conversions are now permanent. “I warn clients that there are no do-overs,” Karakachian said.