Roth Conversions While the S&P is Down 13.61% Year to Date?

As we go to press, the S&P 500 is down 13.61 year-to-date. How does this affect your Roth IRA conversion strategy? If you were a good candidate to make a Roth IRA conversion, should you make it now? If so, should you invest the Roth the same way you would invest funds in IRAs or retirement plans, or after-tax brokerage accounts?

Unfortunately, they don’t ring a bell when the market hits the top or bottoms out. Since I am not a market timer, I usually don’t even consider the market as a critical marker for either making or not making a Roth conversion.

Furthermore, I am not going to predict which way the market is going from here. Maybe we had an overheated market, and this correction is permanent or long-lasting. Maybe the market will go back to previous highs and beyond by the end of the year. Honestly, even economists can’t agree and even if they did, they could all be wrong.

That said, now is a much more attractive time to make a Roth conversion than on January 1, 2022, when the market was 13.61% higher than today. Given that, what observations can I make that will help guide your decision-making?

One common mistake I see when I review a potential client’s Roth investments has to do with asset allocation and the less discussed strategy of asset location. Frequently, the asset allocation for their Roth accounts is like their other investment accounts. For example, if they are a 60% stock and 40% bond investor, they often have their Roth invested the same way.

The consideration of asset location comes into play on a somewhat finer scale. Your Roth investments should be invested much differently than your traditional IRAs and retirement plans and even your after-tax brokerage accounts because of their likely long investment time horizon in your portfolio.

We normally advocate that subject to exception, the last dollars you should spend are your Roth dollars—the tax-free growth of Roths is generally something you want to maintain for as long as legally possible. If you have Roth accounts, you likely have other investments and other retirement accounts that you will spend first and those accounts will probably take you through your retirement. That means you, and if you are married, your spouse will likely die with your Roth IRA intact, and likely it will have grown substantially.

Your beneficiaries, in keeping with the dreaded SECURE Act, will no longer be able to defer distributions from the inherited Roth over the course of their lives, but they will be able to defer distributions for ten years after you and your spouse die.

Let’s assume, that you think you and your spouse have a 30-year joint life expectancy (which means only one of you must survive for 30 years). Let’s also assume that neither you, your spouse, nor your ultimate beneficiary needs the Roth money over the next 40 years because there are other funds to spend. That provides you with a potential 40-year tax-free investment horizon.

Under those circumstances, it probably makes sense to alter your asset location strategy with a longer time frame in mind for the Roth investments. For instance, rather than focusing on a well-diversified portfolio or even a portfolio heavily weighted in large U.S. companies or an S&P Index fund, why not invest the Roth in asset classes that have historically done better in the long run?

It is axiomatic for advisors to caution past performance is no guarantee of future results. That said, small-cap or value company stocks have significantly outperformed large-cap companies in the long run. Investopedia reports that over the same period, small-cap funds yielded an average annual return of 9.12% and large-cap funds yielded a return of 7.12%. Yes, they are more volatile, but with a 30- or 40-year investment horizon, long-term performance should outweigh concerns over volatility. There are arguments why small cap/value companies will do better or worse in the next year or even ten years. Again, I am not so interested in their short-term performance. A better question is which asset class will likely outperform in the long run?

In addition, since the Roth IRA grows tax-free, you can invest in assets that are tax-inefficient like an index fund that throws off phantom gains. Other index funds can be designed to be at least somewhat tax efficient. A likely asset location for that type of asset would be an after-tax brokerage account. But the index funds that are not designed to be tax efficient belong in either IRAs or Roth IRAs. This is a prime example of asset location—that is to say where you place investments with different investment characteristics.

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All written content is provided for information purposes only and is not tax or legal advice. Information and ideas provided should be discussed in detail with an advisor, accountant, or legal counsel prior to implementation. Past performance may not be indicative of future results. All investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.