Dollar cost averaging is an investment strategy where a fixed amount of money is invested on a regular basis, for example, monthly. There are several advantages to the investor to utilize dollar cost averaging. These same advantages apply to converting money in a traditional IRA into a Roth IRA. However, the conversion advantages of this strategy is to minimize income tax incurred from the conversion and thus maximize long-term investment returns.
- In dollar cost averaging, an investor purchases a set amount of an investment monthly.
- In “reverse dollar cost averaging”, an investor regularly sells shares of a traditional IRA to convert money into a Roth IRA.
- By using this strategy, an investor can maximize long-term investment returns
What is a Roth IRA conversion?
There are essentially two types of IRAs: traditional IRAs and Roth IRAs. The rules about who can contribute to them and how they are taxed are a bit complicated. Both types of IRAs are subject to federal and state income tax but the differences are in when you pay those taxes: when you put the money in (during your working years) or when you take the money out (during retirement years).
- Traditional IRAs. In 2023, you can contribute $6,500 into a traditional IRA ($7,500 if you are over age 50). For tax purposes, the IRS divides money in your IRA into two categories: the amount you initially contributed (the IRA contribution amount) and the amount that you made in profit from that initial contribution (the IRA profit amount). Everyone pays regular federal and state income tax on the traditional IRA profit amount when that money is taken out of the traditional IRA in retirement. But when it comes to the contribution amount, things get complicated and taxation depends on your annual income for the year of that contribution and your IRS filing status for that year.
- Filing single. If you are covered by an employer retirement plan and your 2023 income is less than $73,000, then your traditional IRA contributions are all pre-tax, meaning that you do not pay income tax on those contributions until you withdraw the money in retirement. If your 2023 income is greater than $83,000, then your traditional IRA contributions are all post-tax, meaning that you pay income tax on those contributions this year, when you earned the money for those contributions. Then, in retirement, you do not have to pay any income tax on the withdrawals for the amount that you initially contributed. If your income is between $73,000 and $83,000, there is a phase-out, meaning that some amount of your contributions are pre-tax and some amount are post-tax.
- Married filing jointly. If you are married and the spouse making the IRA contribution is covered by a workplace retirement plan, the income limit for pre-tax contributions is $116,000. All contributions are post-tax if the annual income is greater than $136,000. There is a phase-out if the income is between $116,000 and $136,000. However, if you are an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the phase-out range increases to between $218,000 and $228,000
- Roth IRAs (direct contributions). There are two ways you can contribute to a Roth IRA, either directly or by doing a traditional IRA to Roth IRA conversion. All contributions to Roth IRAs (regardless of annual income) are post-tax meaning that you pay federal and state income tax this year on any contributions you make this year. When money is withdrawn in retirement, all withdrawals are tax-free. The amount that the IRS allows you to contribute directly to a Roth IRA depends on your annual income for the year that you make the contributions.
- Filing single. If your 2023 income is less than $138,000, then you can make direct contributions to a Roth IRA of up to $6,500 (or $7,500 if you are over age 50). If your annual income is greater than $153,000, then you cannot contribute any amount directly into a Roth IRA. If your income is between $138,000 and $153,000, then there is a phase-out, meaning that you can contribute directly to a Roth IRA but less than the usual maximum amount of $6,500 ($7,500 if over age 50).
- Married filing jointly. The income limit for direct contributions to a Roth IRA is $218,000. If the annual income is less than that, then both spouses can directly contribute up to $6,500 each ($7,500 if over age 50) into a Roth IRA. If the household income is greater than $228,000, then neither spouse can make direct contributions to a Roth IRA. There is a phase-out if the income is between $218,000 and $228,000 resulting in a maximum direct contribution to a Roth IRA of less than $6,500 ($7,500 if over age 50).
- Roth IRAs (conversion contributions). The second way of contributing to a Roth IRA is by doing a traditional IRA to Roth IRA conversion. This is sometimes called a “backdoor Roth” since the IRS code allows a person to first contribute money into a traditional IRA and then promptly convert that money into a Roth IRA. This strategy is used by people whose income is too high to directly contribute to a Roth IRA but it is also used by anyone who already has money in a traditional IRA and wants to move some of that money into a Roth IRA. There is no limit to the amount that you convert in any given year – you can convert as much as you want. However, the conversion is considered taxable income for that year, so the more you convert, the higher your annual income and therefore the higher your marginal tax rate becomes. Also, you must leave the amount that you convert in the Roth IRA for at least 5 years before you can withdraw that money without incurring an IRS penalty. You can make as many conversions as you want in any given year. The amount of income tax you pay when doing a Roth IRA conversion depends on whether your previous contributions to your traditional IRA were post-tax contributions, pre-tax contributions, or a mixture of the two.
- Pre-tax traditional IRA contributions. If all of your previous contributions to your traditional IRA were made with pre-tax money, then you will pay regular federal and state income tax on the full amount that you convert to a Roth IRA.
- Post-tax traditional IRA contributions. If all of your previous contributions to your traditional IRA were made with post-tax money, then you will pay regular federal and state income tax on the profit amount of the traditional IRA but you will not pay income tax on the contribution amount that you made to that IRA. This require you to keep a record of the amount of post-tax contributions that you make to your traditional IRA every year. When you convert a portion of your traditional IRA into a Roth IRA, the IRS requires you to calculate the percentage of the conversion that is from the profit amount and the percentage that is from the contribution amount in order to determine your income tax.
- Mixed traditional IRA contributions. Here is where things get difficult. You must keep a record of the amount of pre-tax and post-tax contributions to your traditional IRA that you make every year. When doing a conversion to a Roth IRA, you must first determine the percentage of the conversion that is from the contribution amounts and the percentage that is from the profit amounts. Next you determine what percentage of the contribution amounts is from post-tax contributions. You do not pay regular income tax on that percentage of post-tax contributions but you do pay regular income tax on all of the rest of the conversion.
When is the best time to do a Roth IRA conversion?
There are two situations when it is advantageous to do a traditional to Roth IRA conversion. The first is when your current income tax rate is lower than your anticipated income tax rate in retirement. For most people, this is early in their career, when their annual income is lower than it will be later in their career. However, if a person is out of work for a period of time, then their annual income can fall that year, making a Roth IRA conversion worthwhile. Another situation when your income tax is lower is when Congress lowers income tax rates. It is impossible to predict what future income tax rates will be in 5, 10, or 25 years. However, the tax cuts passed in 2017 have given us some of the lowest federal income taxes in memory and it is doubtful that they can go much lower in the future without severe cuts in government programs.
The second situation when it is advantageous to do a traditional to Roth IRA conversion is when there is a significant fall in the stock market. When the value of a traditional IRA falls, then you will pay less income tax on the conversion. Ideally, you would wait for the market to drop and then convert investments in your traditional IRA into similar investments in your Roth IRA. When the market eventually recovers, you will have paid less in taxes than if you had waited and taken the money out of the traditional IRA in retirement. Ideally, you would wait until the market is at its lowest, then do the conversion. The problem with this is that no-one has a crystal ball to see into the future to know when the market has bottomed out. However, it is clear that 2022 was a terrible year for both U.S. stocks (down 19% over the past 12 months) and U.S. bonds (down 13% over the past 12 months).
Reverse dollar cost averaging in 2023
Eventually, the stock and bond markets will recover and the prices for stock and bond mutual funds will increase. It is possible that the markets have already reached a bottom and the only way that they will go is back up. But it is also possible that stocks and bonds will continue to fall in value in 2023. That is the thing about predicting future stock and bond values – you just don’t know until you know and you don’t know until it has already happened. In other words, no one can predict future market values in the short-term. However, we can predict that future markets will be higher in the long-term.
So, 2023 would seem to be a good year to do a traditional IRA to Roth IRA conversion. The stock and bond market has lost a lot of value and we are currently living in a time of historically low income taxes (the 2017 income tax cuts will expire in 2025). But exactly when in 2023 should you do the conversion? This is where the concept of “reverse dollar cost averaging” comes into play.
In dollar cost averaging, a person invests a set amount at regular intervals throughout the year, typically monthly. By doing so, the person buys a lot of shares of of a mutual fund when they are cheap and buys fewer shares when they are expensive. This is a great strategy to ensure that you stick to a retirement savings plan. It also keeps you from trying to “time the market” (no one can accurately predict the future market so trying to time the market is generally unsuccessful). The “average” in dollar cost averaging refers to the result that by buying a few shares each month, then after 12 months, you will have a lot of shares with an average purchase price over the entire year. If you put a certain an amount of your paycheck into your 401k, 403b, or 457 each month, then you are already doing dollar cost averaging.
To see how dollar cost averaging works, let’s take the example of an investor who had $12,000 to invest on January 1, 2022. In the first scenario, the investor thought that the stock market was only going to go up in 2022 and invested the entire amount on January 1st. In the second scenario, the investor invested $1,000 every month for the full year. As it turned out, 2022 was a terrible year for stocks, dropping 19% for the year. The graph below shows the 2022 performance of the Russell 3000 Index, which is a benchmark for the total U.S. stock market.
In the first scenario, the investor who tried to time the market and put the entire $12,000 into a Russell 3000 index fund would have $9,669 at the end of the year. In the second scenario, the investor who used a dollar cost averaging strategy and put $1,000 into a Russell 3000 index fund every month would have $11,050 at the end of the year. Both investors will have lost money but the investor who used a dollar cost averaging strategy would have lost considerably less than the investor who tried to time the market.
You get the same benefit by spreading out your Roth conversions over the entire year. If an investor converted $12,000 of a traditional IRA invested in a Russell 3000 index fund into a Roth IRA that is also invested in a Russell 3000 index fund in January 2022, that investor would have 4.38 shares of the index fund at the end of the year. On the other hand, if an investor converted $1,000 of that traditional IRA into a Roth IRA every month in 2022, then at the end of the year, the investor would have 5.01 shares of the index fund. Now let’s assume that over the next 10 years, the Russell 3000 Index increases by an average of 8% per year. In 10 years, the investor who did one single $12,000 conversion would have $20,876 in the Roth IRA. But the investor who did twelve $1,000 conversions would have $23,857 in the Roth IRA. In other words, the reverse dollar cost averaging approach resulted in the investor having $2,981 more after 10 years.
“Sell high but convert low”
When it comes to maximizing investment returns, the old adage is “buy low and sell high”. But just the reverse is true for Roth conversions when long-term returns can be maximized by converting when the price is low. In essence, in a Roth conversion, you are selling an investment to yourself so that you are selling your traditional IRA low but also buying your Roth IRA low. When you eventually sell your Roth IRA tax-free in retirement, you will come out ahead.
In summary, it is looking like 2023 will be a good year for many people to do a traditional IRA to Roth IRA conversion. But resist the temptation to do one big conversion all at once. Instead, do 12 smaller conversions every month or 6 conversions every two months. When you are retired, you will be happy that you did.
January 7, 2023