Making Lemonade

One strategy to navigate down markets.

There are a lot of levers that can be pulled when the market sells off. I’m not talking about being tactical in allocation, trading options, or being short the market. Today, I wanted to highlight what I have dubbed the “Strategic In-Plan Conversion.”

As I’m sure you know, this is not financial or tax advice. For advice tailored to your situation, speak to your financial and tax professionals. Don’t have a planner?! Shoot me an email :)

There has been a lot of talk about the potential for Roth conversions from pre-tax IRAs during down markets.

This whole idea revolves around the ability to pay taxes on a higher percentage of your total pre-tax assets or a lower balance relative to when markets were at all-time highs.

If you had 100 shares of an ETF that was worth $20,000 and it is now worth $16,000, you could have that amount converted and hopefully, over time it can recover. Instead of paying taxes on $20,000, you are only paying taxes on $16,000.

If you previously had a Traditional IRA with $1,000,000 and the sell-off brought it to $800,000, you can convert the same dollar amount to a Roth IRA; however, a larger percentage of the account is now converted.

Converting $100,000 of the original balance would only result in 10% of your balance being converted. Doing $100,000 of the $800,000 allows for 12.5% of your pre-tax asset base to be converted.

Now, the idea I am going to lay out is a bit more in-depth, but it follows a similar concept.

Many 401(k) plans now offer in-plan conversions. This is incredibly useful for those taking advantage of the Mega Backdoor Roth. More on the Mega Roth here.

Essentially, what I am dubbing the “Strategic In-Plan Conversion” is a at its core, a Roth conversion within a 401(k).

However, for people who are still earning and contributing on a pre-tax basis, the strategy is to find a spread between the amount converted and what you were able to contribute on a pre-tax basis.

Let’s say Person A contributed the maximum to their 401(k), which is $23,500. They effectively avoided or deferred federal and state income taxes on that amount.

Now, let’s say the market performed miserably. For the example, we’ll use a 35% drawdown. Person A’s $23,500 pre-tax contribution is now worth only $15,275!!

That is no fun. But there is an opportunity here. Person A did not pay taxes on $23,500. However, they can have their remaining balance of $15,275 converted to the Roth portion of their 401(k).

This will result in $15,275 being taxed as ordinary income. So, we have effectively contributed $23,500 as pre-tax dollars and paid taxes on $15,275.

Offering us a spread of $8,225 that was not subject to taxes… and the icing on the cake? When those Roth dollars are distributed during retirement, they will not be taxable.

At an effective tax rate of 30%, this is tax savings of $2,468, and rather than letting poor performance rain on our parade, Person A still had a net reduction in this year’s taxes but also has $15,275 Roth dollars in their 401(k).

It’s a bit tricky, but when the opportunity presents itself, it can be pretty cool. When the market gets volatile, we’re always looking for ways to make lemonade.