A reader writes in, asking:
“Is there a time of a year when it’s best to do a Roth conversion? Perhaps close to the year end such that a person can estimate their income/AGI, or whenever the market is down in order to make the cost of conversion lower?”
If you have a high tolerance for hassle, doing a conversion ASAP at the beginning of the year is often the best strategy, because you can just change your mind later (up until the due date of your tax return) via “recharacterization” if you don’t like the results. For example, you could recharacterize if:
- It turns out that your income for the year is higher than you expected (meaning that your rate of tax on the conversion is higher than you’d anticipated), or
- The assets that you converted have decreased in value, meaning that you could recharacterize, then do the conversion again later at a lower cost.*
Financial planner Allan Roth has even written about an advanced version of this strategy, in which you do multiple early-in-the-year conversions, with the plan to recharacterize any that you don’t like.
If, however, you are the type who would not bother with a recharacterization, then doing a conversion when the market is down would make sense — at least in theory — because that would be the time that the conversion is least expensive (both because the account balance is smaller and because that is when it would usually be most advantageous to liquidate taxable holdings in order to help pay the tax on the conversion).
There is, however, a downside to the strategy of waiting for a market downturn. In short, it leaves you playing a market-timing-style guessing game. For example, imagine that you plan to do a conversion this year, and you decide to wait until a market downturn. What if the market goes down, say, 3{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} in January? Do you convert then, or do you wait in the hope that it goes down further later in the year? There’s no way to know which answer is right. Or, what if the market has a great year, never going below the point at which it started? In such a case you’d be left having to eventually convert in December at a high point, thereby having to pay a higher cost than if you’d just gone ahead and done it at the beginning of the year.
If you don’t want to bother with recharacterizations or market timing guessing games, then:
- Doing conversions late in the year makes sense if you have a high degree of uncertainty about your income/deductions (because, near the end of the year, you would no longer have as much uncertainty, thereby making it easier to determine what your tax rate would be on the conversion and whether or not the conversion would be advantageous), and
- Doing conversions early in the year makes sense if you know it will be a good year for a conversion (with the reason being that the market typically goes up over time, so an early conversion is typically going to be less costly than a conversion at a later point).
*To do a second conversion of a given amount (that is, after undoing the first via recharacterization), you must wait until the later of a) 30 days after the recharacterization or b) the year following the year of the conversion.
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SOURCE: Oblivious Investor – Read entire story here.
