In a bear market, traditional IRA accounts holding individual stocks may have a number of depressed securities.  For tax purposes, this could be an advantageous time to convert some/all such positions with the greatest price declines to a Roth IRA or, alternatively, to take “in-kind” distributions of these positions.  While either strategy will generate current year income, it will be based on the depressed prices.  All future gains will be tax free under the Roth conversion or taxed at capital gains rates as opposed to regular income rates, under the “in kind” distribution.  In either case, the assumption is that the investor has conviction in the eventual success of the underlying businesses and therefore, in the eventual rebound and outperformance of the stocks.

Roth conversions are transfers of existing positions – stocks, bonds, etc. – from a traditional IRA to a Roth account at one’s brokerage.  Income tax will be due for the year of the conversion based on the market value of the position(s) at the time of conversion, but future distributions from the Roth account, of principal and any gains, will be tax and penalty free as long as the securities (or their proceeds) are held in the Roth IRA for at least 5 years.  All conversions in a given tax year are considered to have been made on Jan. 1, for purposes of starting the 5-year clock.  Therefore, a conversion on Dec. 31 only has to be kept for 4 years and a day before being eligible for a tax-free withdrawal.

If one’s holding period for a depressed investment is, for cash flow needs or other reasons, less than 5 years – the timeframe to qualify for tax-free withdrawals under Roth IRAs above – then taking an “in-kind” distribution of the security, i.e., transferring it to one’s individual taxable account, may make better sense.  After paying taxes on the transferred value, all future gains, after a year, will be taxed at capital gains rates, currently 0%, 15%, or 20%, depending on overall income.  These are usually more favorable than corresponding ordinary income rates.  Thus, the majority of taxes to be paid on a depressed security that is transferred “in kind” may be based on long term gains, not ordinary income.

Roth conversions or “in kind” distributions should be considered in years when individual portfolio positions are significantly distressed, there is an expectation that future income will be higher than at present – due to job-related raises, rebounding markets, and/or the commencement of Social Security and pension payments – there is cash available to pay the additional taxes, and there is a firm conviction in the investments’ ultimate success.  Under the right conditions, the majority of the realized returns may be free of tax or taxed as gains, not income.

This article, as with any articles on this site, should not be considered as actionable advice. Please consult a tax and/or a financial professional for advice suitable to your individual situation.