Potential “tax wash” Roth conversions during big market drops?

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samsdad
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Potential “tax wash” Roth conversions during big market drops?

Post by samsdad » Wed Oct 10, 2018 8:49 pm

I was reading an old thread about RBDs just for fun and came across a response about 4 pages into it which kinda stopped me in my tracks. During the discussion, a boglehead stated:
. . . I convert money from IRA to Roth after market slips about 10% (and pay taxes on the conversion). When markets rebounds, all the gains would be tax-free.
It stopped me thinking about RBDs and wondering if this is a legitimate tax strategy.

Let’s change it a little. Say I’m in the 22% tax bracket and any conversion amount I might do wouldn’t put me into another. Would I have to wait till the market dropped 22% to convert and recoup any taxes I might pay? (Presume the market goes back up for this hypothetical.)

In other words is this a way to convert to Roth basically with a “tax wash”—a sort of tax-loss harvesting for the tax-advantaged accounts? I was going to originally say “tax free” but obviously taxes would still be paid.

Church Lady
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Church Lady » Wed Oct 10, 2018 10:05 pm

It stopped me thinking about RBDs and wondering if this is a legitimate tax strategy.
Yes, of course it is legitimate in the sense that it is legal, ethical, and sensible. What more do you want from a tax strategy? :D
Say I’m in the 22% tax bracket and any conversion amount I might do wouldn’t put me into another. Would I have to wait till the market dropped 22% to convert and recoup any taxes I might pay? (Presume the market goes back up for this hypothetical.)
I'm not sure what you're asking. :? Suppose your balance before the selloff is B, and your marginal tax rate is M. Let m = M/100 (that is, express your marginal tax rate as a decimal). Your taxes on conversion would be B*m if you convert at this moment.

Now your IRA holdings drop X%, so let x = X/100 (express percentage as a decimal). Your new balance is (1-x)B, so you pay taxes on this conversion of (1-x)Bm = Bm - xBm. Or to put it another way, your tax savings if you convert after the selloff is xBm.

What do you want xBm to equal?

Incidentally, I am thinking in-kind conversions are the way to go here. In-kind means you move your holdings into the Roth instead of cashing out your position and moving cash into the Roth.
He that loveth silver shall not be satisfied with silver; nor he that loveth abundance with increase: this is also vanity. Ecclesiastes 1:8

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Peter Foley
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Peter Foley » Wed Oct 10, 2018 10:41 pm

So what is an RBD?

Edit to clarify.

1. Sometimes when acronyms are used readers do not understand them. Please use them sparingly.
2. "Really Bad Day" lacks definition. There was a really bad day in 1929, another one in 1987, and another one shortly after 9/11/2001.

I would not do a Roth conversion after a 3% drop as we had yesterday. Perhaps after a 10% market correction I would take the time to do an analysis.
Last edited by Peter Foley on Thu Oct 11, 2018 9:28 am, edited 1 time in total.

Church Lady
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Church Lady » Wed Oct 10, 2018 11:02 pm

RBD = Really Bad Day
He that loveth silver shall not be satisfied with silver; nor he that loveth abundance with increase: this is also vanity. Ecclesiastes 1:8

Church Lady
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Church Lady » Thu Oct 11, 2018 12:13 am

Now that I have had my shower, I see what you are asking ... I think.

The answer depends on how much you want to recoup.

Suppose you pay the conversion taxes from some taxable account and not from the converted funds itself, so that

balance after crash = balance after conversion = B(1-x)
To restore the balance to B, your holdings have to increase by xB.
If you define the recoup as the taxes you would have paid on the pre-crash balance (mB),
you want
xB = mB
x = m

So yes, you want a crash equal to your marginal tax rate, followed by a recovery to your original IRA
balance, to recoup the taxes you would pay on the pre-crash balance.

But wait! After the crash, you didn't pay mB. You paid mB(1-x). You only need to recoup
mB(1-x) to recoup taxes actually paid. So

xB = mB - mxB
x = m - mx
x + mx = m
x(1 + m) = m
x = m / (1 + m)

This implies you need wait for a drop of about 18% followed by a recovery to the account's original value.

Is this what you wanted to know?
He that loveth silver shall not be satisfied with silver; nor he that loveth abundance with increase: this is also vanity. Ecclesiastes 1:8

samsdad
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by samsdad » Thu Oct 11, 2018 5:35 am

Now that I have had my shower,
I thought you said this was legal, ethical and sensible!

All kidding aside, yes, I think that's what I'm looking for. I typed up my original post last night after a long day. So let me try it a different way, though, just to make sure.

I'm looking for a way to convert my tIRA to Roth without a tax hit.

There's a way to do this if you don't have any earned income or rental income, etc. up to whatever year's deductions, tax credits you might have. For example, this year you get a 24k standard deduction. In terms of federal taxes, if you earn 24k you don't pay any federal taxes. (Indeed, you could earn 24k and have 77.2k in long-term capital gains and still not owe a dime in federal taxes.) So, absent other earned income, if you convert 24k of tIRA to Roth, you don't have a tax drag--at least that's my understanding regarding how Roth conversions are counted as income.

If I converted before the big drop, I'd have to pay 22% of my conversion in taxes (let's simplify everything and forget about other deductions/tax credits I may or may not have). If I wanted to recoup that tax-loss/tax-drag--whatever you want to call it--I could bet that the market would go back up eventually, pay the taxes this year on that income, and have the market pay me back, without having to wait till I find myself in the position in life of not having earned income, rental income, etc. that incurs a tax drag before doing the conversion.

So, you think I'd have to wait for a 18% drop to do this if I'm at the 22% bracket?

samsdad
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by samsdad » Thu Oct 11, 2018 5:52 am

By the way, in the abstract, I think this strategy is fraught with danger, is arbitrary and capricious, vague and ill-defined, and otherwise seems very suspect.

On the other hand, not having a tax drag on money coming out of a tIRA that also escaped the tax man on the way in kinda seems like cheating death, twice, and therefore is rather intriguing to me.

I'm guessing that I haven't seen this strategy discussed before for some reason or reasons. Perhaps because it's been awhile since we've had a huge drop; or because of the aforementioned vagueness of the strategy; or because I don't read enough around here.

rkhusky
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by rkhusky » Thu Oct 11, 2018 7:26 am

If you are paying 22% to do a Roth conversion, the only way to come out ahead is if your marginal rate when withdrawing from your tIRA would be greater than 22%. It doesn't matter what the market had done or will do. (caveat - if you are maxing all tax advantaged accounts, then you come out ahead if your marginal tIRA withdrawal rate is approximately greater than 17%)

samsdad
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by samsdad » Thu Oct 11, 2018 9:44 am

rkhusky wrote:
Thu Oct 11, 2018 7:26 am
If you are paying 22% to do a Roth conversion, the only way to come out ahead is if your marginal rate when withdrawing from your tIRA would be greater than 22%. It doesn't matter what the market had done or will do. (caveat - if you are maxing all tax advantaged accounts, then you come out ahead if your marginal tIRA withdrawal rate is approximately greater than 17%)
Now that I have time to do the math, I don’t think it works realistically.

Example:
Day 1, I have $100k in tIRA.
Day 2, the market drops 18%. I convert to Roth on the $82k that the tIRA is now worth. I have an ~ $18k tax bill since I’m in the 22% tax bracket.
Day 3 I withdraw the $18k to pay the tax bill, leaving about $64k in the market which stayed flat that day.
Day 4 I pray the market goes up 56.25% sometime in the near future to get me back to $100k.

Not a great plan methinks.

JBTX
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by JBTX » Thu Oct 11, 2018 10:18 am

rkhusky wrote:
Thu Oct 11, 2018 7:26 am
If you are paying 22% to do a Roth conversion, the only way to come out ahead is if your marginal rate when withdrawing from your tIRA would be greater than 22%. It doesn't matter what the market had done or will do. (caveat - if you are maxing all tax advantaged accounts, then you come out ahead if your marginal tIRA withdrawal rate is approximately greater than 17%)
I struggled thinking through this a while. It just seems like doing a conversion when the market is down is a favorable thing to do. Many years ago I converted a boat load of traditional from a 401k rollover in 1998 when the market was way down, and I was proud of myself for pulling that off. But in retrospect it doesn't matter.

Where it does matter a bit is if you do it from taxable savings and assuming you maxed out your tax deferred opportunities (which was true) you are effectively putting more into tax deferred status and buys you a few points on the marginal tax rate curve.

In spite of this I'm not unhappy I did it, even though marginal tax rates were a bit higher then. In my case I'm not sure I would have diligently kept those amounts (conversion taxes paid) invested for retirement in equity funds for 30 more years. I may have kept more in cash, may have bought bigger house, may have spent more. I suspect all of the above.

Church Lady
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Church Lady » Thu Oct 11, 2018 10:36 am

samsdad wrote:
Thu Oct 11, 2018 5:35 am
Now that I have had my shower,
I thought you said this was legal, ethical and sensible!

All kidding aside, yes, I think that's what I'm looking for. I typed up my original post last night after a long day. So let me try it a different way, though, just to make sure.

I'm looking for a way to convert my tIRA to Roth without a tax hit.

There's a way to do this if you don't have any earned income or rental income, etc. up to whatever year's deductions, tax credits you might have. For example, this year you get a 24k standard deduction. In terms of federal taxes, if you earn 24k you don't pay any federal taxes. (Indeed, you could earn 24k and have 77.2k in long-term capital gains and still not owe a dime in federal taxes.) So, absent other earned income, if you convert 24k of tIRA to Roth, you don't have a tax drag--at least that's my understanding regarding how Roth conversions are counted as income.

If I converted before the big drop, I'd have to pay 22% of my conversion in taxes (let's simplify everything and forget about other deductions/tax credits I may or may not have). If I wanted to recoup that tax-loss/tax-drag--whatever you want to call it--I could bet that the market would go back up eventually, pay the taxes this year on that income, and have the market pay me back, without having to wait till I find myself in the position in life of not having earned income, rental income, etc. that incurs a tax drag before doing the conversion.

So, you think I'd have to wait for a 18% drop to do this if I'm at the 22% bracket?
Well, you've changed the discussion a little bit. But here goes.

Given that it is a good idea for you to do a Roth conversion at marginal rate M, you will definitely pay less taxes if you convert when the balance is lower. Even if your balance never recovers, you will still pay less taxes on the conversion if you wait until such time as the balance is lower.

Given that your balance recovers to where it was before in your lifetime, we have calculated that if you convert when the pullback is m/(m+1), about 18% in your case, you'll make up the tax payment.

But you have introduced elements of whether a conversion at marginal rate m is a good idea when you say
without having to wait till I find myself in the position in life of not having earned income, rental income, etc. that incurs a tax drag before doing the conversion.
So let's talk about that. There are many threads discussing whether it is a good idea to convert at marginal rate M, so we won't rehash that here unless you want to. However, if you wait for a low bracket to occur, you might find it never happens -- a high quality problem!

Or if it does, you may find there's not enough space in the lower bracket to convert as much as you'd like to convert.

This is my situation. Maybe it's hubris; maybe God is giggling as I type this, but I don't expect my marginal rate ever to be lower than 22%, and I don't have enough time to convert as much of my tax deferred account below my MRMD marginal rate as I'd like.

Of course, we may both find that tax law changes so drastically, Roth conversions were the worst possible strategy. That's the trouble with the future; it's unpredictable! You can only hedge your bets.
He that loveth silver shall not be satisfied with silver; nor he that loveth abundance with increase: this is also vanity. Ecclesiastes 1:8

Church Lady
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Re: Potential “tax wash” Roth conversions during big market drops?

Post by Church Lady » Thu Oct 11, 2018 11:09 am

samsdad wrote:
Thu Oct 11, 2018 9:44 am
rkhusky wrote:
Thu Oct 11, 2018 7:26 am
If you are paying 22% to do a Roth conversion, the only way to come out ahead is if your marginal rate when withdrawing from your tIRA would be greater than 22%. It doesn't matter what the market had done or will do. (caveat - if you are maxing all tax advantaged accounts, then you come out ahead if your marginal tIRA withdrawal rate is approximately greater than 17%)
Now that I have time to do the math, I don’t think it works realistically.

Example:
Day 1, I have $100k in tIRA.
Day 2, the market drops 18%. I convert to Roth on the $82k that the tIRA is now worth. I have an ~ $18k tax bill since I’m in the 22% tax bracket.
Day 3 I withdraw the $18k to pay the tax bill, leaving about $64k in the market which stayed flat that day.
Day 4 I pray the market goes up 56.25% sometime in the near future to get me back to $100k.

Not a great plan methinks.
Are you saying don't do Roth conversions at all? Or don't keep your IRAs in the market?

A huge premise of Bogleheads is that the market is always trending g up in our lifetimes. If we did not believe that, we'd hold fixed income only in our IRA accounts, and OP would not have posted his question. OP clearly believes in market recovery. YMMV.

Suppose OP never converts the funds to Roth. He won't get the whole 100K when he takes the money out; he has to pay tax at whatever his marginal rate is at the time. To break even, he only needs his Roth to recover to its former value less whatever tax he would pay at withdrawal time. If we had a time frame (which OP has not provided) we could fudge a bit for the time value of money, but I think you get my point. In a t-IRA, the balance may be B, but you share that balance with Uncle Sam.
He that loveth silver shall not be satisfied with silver; nor he that loveth abundance with increase: this is also vanity. Ecclesiastes 1:8

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