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How to Maximize Your Roth IRA During a Bear Market

During periods of extreme market volatility, like we’ve had during the first quarter of 2020, wise long-term investors will find ways to channel their angst (over things they can’t control) into taking a strategic look at their accounts for potential long-term tax planning opportunities.

For those of us who have both traditional (pre-tax) IRAs and Roth IRAs, now is a good time to review the types of investments held in each of those accounts. As a quick review, here are the tax treatments of different types of income in each of these accounts:

Traditional IRA

  • Your original (pre-tax) contributions to the account will be taxed upon distribution at ordinary income tax rates (similar to wages)
  • Dividends and interest are tax deferred while they remain in the IRA, but will be taxed as ordinary income when they are distributed from the account
  • Capital gains are tax deferred while they are in the IRA, but they will also be taxed as ordinary income when they are distributed from the account (unfortunately, they do not qualify for the more favorable long-term capital gains tax rates)

Roth IRA

  • Your original (after-tax) contributions to the account will not be taxed upon distribution
  • Dividends, interest, and capital gains earned are tax free while in the Roth and no tax is owed upon distribution

Based on the significant difference between taxation of distributions from these two accounts (all taxed as ordinary income vs no tax at all), the most aggressive long-term investments in your overall portfolio (typically US, International, and Emerging Markets stock funds) should be held in the Roth. Your overall allocation to bond funds are better suited for the traditional IRA since they are less likely to grow over time, and the income (dividends) they generate will benefit from the tax deferral offered by the IRA until you make distributions.

Below is a simplistic example of an investor who has both a traditional IRA and a Roth IRA with identical balances of $250K at the beginning of the year, as well as identical stock vs bond allocations of 60% and 40%, respectively.

After experiencing a 33% stock market downturn (similar to what we experienced during the first quarter of 2020), their accounts now look like the following:

Now, let’s assume that 1) this investor doesn’t make any changes to their portfolio, 2) the bond funds hold their same value over the next 10 years, and 3) the value of the stock funds not only recovers the $100K from the recent market drop, but also increases by another $100K over 10 years. If this investor distributes all of their investments from both accounts after 10 years and pays an effective tax rate of 25%, the results would be as follows:

Alternatively, if this investor had rebalanced their holdings right after the current market downturn, and effectively transferred as much of the stock fund holdings ($100K) as possible from their traditional IRA to their Roth IRA, the pre-recovery portfolio would have looked like this:

When this portfolio experiences the same recovery as the original portfolio, and the full distribution takes place after 10 years, the after-tax proceeds are now $25K higher, as shown below.

In summary, the investor in the example above has significantly reduced their lifetime taxation on total IRA distributions without taking on any additional risk by simply holding different allocations of investments in their accounts over an extended market recovery. If you have multiple types of IRAs and have been impacted by the market downturn, this is a perfect time for you to take a close look at your allocations to see if you might benefit from some long-term tax planning through strategic rebalancing in the accounts.

Paul Hansen, CFP®, CPA


This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Community First Bank, HFG Trust, and HFG Advisors have no duty or obligation to update the information contained herein. Further, Community First Bank, HFG Trust, and HFG Advisors make no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services, banking services, or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Community First Bank, HFG Trust, and HFG Advisors believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be copied, reproduced, republished, or posted in any form without the prior written consent of Community First Bank and/or HFG Trust and/or HFG Advisors. HFG Advisors, Inc, is a wholly owned subsidiary of HFG Trust, LLC. HFG Trust, LLC is a Washington state-registered Trust company and wholly owned subsidiary of Community First Bank.