Despite some wildfires here and there, the summer of 2023 has been very kind to investors. The strange concentration of investment returns has continued, inflation has declined at a study pace, and the economy hums along.

This is great news, but sadly there is no peace or good news that will ever satisfy me. Everyone else can go play in the sun but around here we are always planning and maintaining constant vigilance. It’s when things are going well that we should revisit what someone could have done when things weren’t so nice. Let’s look back at 2022:

Though US Stocks collectively fell 19% back in 2022, things may have been different depending on how you were invested. Above is what the industry calls a style box, and it splits companies into the categories of Large-Cap Companies (Mega-Caps are absorbed into “Large” in this case), Small-Cap Companies, Value Companies, and Growth Companies. Mid-Cap companies are usually represented here as well but, in this case, they were absorbed into the other categories.

In summary, everyone lost, but some lost more than others. So, despite the negative market performance, what did you do to make the best out of a bad situation?

One option was to complete a Roth conversion. Let’s see how a Roth Conversion done in 2022 could have set you up for success in 2023 and beyond.

However, before we get to the math part (everyone’s favorite), Let’s go over some basics.

A Roth Conversion transfers funds from your tax deferred IRA account to your tax-exempt Roth account. If you recall from my Why Do We Own Stocks series, IRAs and Roth accounts are tax advantaged accounts, meaning they are granted special privileges by the government in order to encourage retirement saving.

Traditional IRAs and 401ks are the most common retirement accounts and incentivize saving with their tax deferred status. This is a fancy way of saying money you contribute to an IRA reduces your taxable income for the year the contributions are made. Below is an example:

Total Income: $80,000

IRA Contributions: 6,000

Adjusted Gross Income: $74,000

After AGI is calculated you’ll have your itemized or standard deduction to get taxable income. The point is that IRA contributions reduce AGI which will result in less taxable income. The caveat is that the government eventually wants the IRA account spent down so it can collect on the income taxes you deferred paying and the government deferred on receiving. This is why Required Minimum Distributions (RMDs) kick-in for IRAs at age 73. You are required to take a minimum amount out of the IRA (you can still take out more than the RMD) and the distribution is taxed as ordinary income.

The Roth operates a little differently. A Roth or Roth 401k allows people to make after-tax contributions that then grow tax free. Let’s see how Roth contributions change your AGI.

Total Income: $80,000

Roth Contributions: 6,000

Adjusted Gross Income: $80,000

As you can see, Roth contributions have no impact on your AGI. There is no tax benefit in the current year, but future earnings can be withdrawn tax free from the account and there are no Required Minimum Distributions.

With that explanation out of the way, let’s start our scenario at the beginning of 2022. Our investor has a Traditional IRA and a Roth IRA.

Then the Federal Reserve attacked by raising interest rates and there was nowhere to hide (I still get chills watching this scene). The stock fund XYZ fell 20% and the bond fund ABC fell 5%. Our investor was in a short-term bond fund and thus missed the 13% decline for aggregate US bond funds.

If this individual was an average investor they might panic and sell out of their stock fund into something safer. If they were above average and practiced the fundamentals they would leave their portfolio alone, knowing it will increase in value over the next couple of years. Instead, this individual was guided by a professional, a financial advisor, who helped them perform a $50,000 Roth Conversion because this was an unexpected opportunity that fit the client’s long-term goals.

Towards the end of 2022, the shares of XYZ which were worth $100 a share at the start of 2022 are now worth $80 share. Think about it. If your investments are diversified, then a market decline means the shares you own are just priced at a temporary discount. Prior to the market decline, a $50,000 Roth Conversion would move 500 shares from the IRA to the Roth. After the decline, they can move 625 shares. Note: The Roth Conversion is a taxable event.

Now let’s look at how things stand today. As of August 24, 2023, the S&P 500 has returned approximately 14% so we will use that as XYZ’s return and a little over 3% for ABC bond fund’s return. Things don’t look too bad!

Now let’s fast forward 10 years to 2033. I have the stock fund XYZ generate a 6% annual return and the bond fund ABC generate a 2% annual return. I also have what the portfolio would look like with the Roth Conversion back in 2022 and without the Roth Conversion. I am also assuming the investor has an effective tax rate of 20%, because why not.  

To make the tax benefit obvious, if the investor were to liquidate their entire portfolio in 2033, the scenario where they didn’t perform the Roth Conversion results in nearly $20,000 ($56K tax bill vs $36K) in more taxes. You can imagine the potential tax savings the longer you allow investment returns to compound which is why Roth Conversions can be an effective estate planning strategy for some individuals.

This is a simple example and there are still other important planning things to note here such as how taxes are paid the year of the Roth Conversion, whether future taxes are expected to be higher or lower, etc. Still, I hope the biggest takeaway is that even when markets are down there are opportunities to take advantage of.

Addendum: Financial Friction

A philosophical reason for why I think Roths are great for young people and Roth Conversions can be worth looking into for older folks, is that Roths provide greater flexibility. They can be better tools than Traditional IRAs because Roths get rid of friction. Friction in finance is anything that interferes with trade: commissions, fees, taxes, etc. I’ll steal that economic definition and say friction is anything that adds complexity to life, which includes taxes. And while taxes are great for funding our government, they can also make things we want appear prohibitively expensive. Let me explain:

I’m fortunate to work with people who are exceptional savers but often forget they can now spend their money. My dad sometimes brings up one such deceased client. This individual had built up a sizable retirement portfolio through years of frugal living. Then one day he called and said he found a new truck he wanted to buy for $50,000. In his entire life he had never purchased a new truck and asked if he could afford it. The client could easily afford the purchase but in the spirit of transparency he was informed that to generate $50,000 after-taxes he would need to sell $60,000 worth of mutual funds. The older client thought that was too much and decided he didn’t want the truck. And he would eventually pass away without ever buying a new truck.

There is a lot to unpack there in terms of building goals for your investments and transitioning from a saver to a spender, but one takeaway is that friction, whether it be time, distance, fees, or taxes, can prevent us from living our best life. Sometimes it is tough to get past the fact that $10,000 of unexpected expenses is a lot but has no impact on your financial plan because this is the moment you’ve spent your entire life saving for. Good financial planning, whether through account or investment selection, does its best to reduce financial friction. That’s one of the nice things about Roth accounts. With a Roth, $50,000 after-tax is $50,000.