Roth Convert in a Down Market: 20% Drop = 20% Off Tax

Margaret and David Ruiz, both 61, file married filing jointly and live in Austin, Texas. In a 2026 bear market their $200,000 traditional IRA dropped 20% to $160,000. Their taxable income before any conversion sits at $90,000. They have $40,000 of cash in a brokerage account earmarked for taxes. The decision in front of them: convert the depressed IRA now, or wait for the market to recover. Converting now means they pay tax on $160,000 instead of the $200,000 the account was worth a year ago — and the $40,000 rebound happens entirely inside the Roth, tax-free. That single timing choice is worth roughly $8,800 in federal tax on the same shares.

Why a price drop is a tax discount

A Roth conversion is taxed on the dollar value you move from a traditional IRA to a Roth IRA on the day you convert — not on the share count, and not on what the account was worth last year. That is the entire mechanism. When the market falls, the same shares are worth fewer dollars, so the taxable amount falls with them.

Picture the Ruizes’ IRA as 1,000 shares of a total-market index fund. A year ago those shares were worth $200/share — $200,000. After a 20% drop they are worth $160/share — $160,000. The 1,000 shares did not change. Their price did. Convert all 1,000 shares now and the IRS taxes you on $160,000. When the price recovers to $200/share, those 1,000 shares are worth $200,000 again — but now they sit in a Roth, and that $40,000 of recovery is never taxed.

Convert the same 1,000 shares after they recover and you pay tax on the full $200,000. You moved identical shares either way. The only variable was the price on conversion day, and a depressed price is a one-time discount on the tax bill for capturing the rebound on the Roth side.

The math: $200K IRA down 20%

Here is the side-by-side for the Ruizes’ full-account conversion, comparing converting at the depressed $160,000 versus waiting for the $200,000 recovery. Their other income is $90,000, so the conversion stacks on top of that.

The $8,800 figure is the 22% rate applied to the $40,000 of price decline. Roughly stated: a 20% drop equals 20% off the taxable amount, and at a 22% bracket that translates to about 4.4% of the original balance saved in tax (20% × 22% = 4.4% of $200,000 = $8,800). The deeper the drop, the larger the discount on the identical shares.

How drop depth scales the discount

The tax discount is linear in the size of the decline, so it pays to know what each level of drawdown is worth before you act. Holding the Ruizes’ $200,000 starting balance and a 22% bracket constant, the savings on the identical 1,000 shares scale directly with how far the price has fallen on conversion day.

A 30% bear-market drawdown — roughly the depth of the 2020 COVID selloff or the 2022 peak-to-trough — converts $140,000 instead of $200,000 and saves $13,200 in federal tax at a flat 22%, while moving the same 1,000 shares. The table assumes the entire conversion fits in the 22% bracket; in practice the Ruizes’ $90,000 of other income means a six-figure conversion partly lands in 24%, which is exactly why sizing matters (covered below). The takeaway holds regardless: every percentage point the price is depressed is a percentage point off the toll to cross into the tax-free Roth.

Condition 1: pay the tax from outside funds

This is the rule that makes or breaks the strategy. The Ruizes converting $160,000 owe federal tax on it. They must pay that tax with the $40,000-plus of brokerage cash they set aside — never by withholding from the IRA itself.

Two things go wrong if you fund the tax from the IRA. First, if you are under 59½, any amount withheld from the IRA to cover the tax is itself a distribution — and an early one. It gets hit with a 10% early-withdrawal penalty under IRC §72(t) on top of the income tax. Second, even at any age, every dollar pulled out to pay tax is a dollar that never reaches the Roth, permanently shrinking your tax-free base and forfeiting decades of tax-free compounding on it.

• Right way: convert the full $160,000 into the Roth; pay the ~$35,200 of tax from a taxable brokerage account. All $160,000 of depressed shares compound tax-free.
• Wrong way (under 59½): withhold $35,200 from the IRA to cover tax. Only ~$124,800 reaches the Roth, and the $35,200 withheld draws a $3,520 penalty under §72(t) plus the income tax.
• Net effect of paying outside: you effectively shelter more by using after-tax dollars to buy a tax-free wrapper around the entire converted balance.

The Ruizes are 61, so the 10% penalty does not apply to them — but the base-shrinking problem still does. Paying the tax from outside is the move at every age.

Condition 2: the conversion stacks on your ordinary income

A conversion is not taxed in a vacuum. It is ordinary income that stacks on top of everything else on your return, and it can trip three separate thresholds.

Federal brackets

For 2026, the 22% bracket runs to $103,350 (single) and $206,700 (MFJ). The Ruizes have $90,000 of other income, leaving only about $116,700 of room under the $206,700 MFJ ceiling before they hit 24%. A full $160,000 conversion spills roughly $43,300 into the 24% bracket. That is not a reason to skip the conversion — it is a reason to size it, or to spread it across two tax years to stay in 22%.

IRMAA — Medicare premium surcharges

A conversion raises modified adjusted gross income (MAGI), and MAGI drives IRMAA, the income-related surcharge on Medicare Part B and Part D. 2026 premiums are based on 2024 MAGI, and the surcharges step up at $206,000 MFJ. The first IRMAA tier (MFJ MAGI $206K–$258K) pushes the Part B premium from $185 to $259 per person per month — about $1,776/year extra for a couple. Converting in the years before Medicare starts (or before the two-year MAGI lookback hits) sidesteps this.

ACA premium credits

If you buy health coverage on the ACA marketplace before Medicare, conversion income raises MAGI and can claw back premium tax credits. For early retirees in their early 60s — exactly the Ruizes’ situation if they were not yet on Medicare — a large conversion can erase thousands in subsidies. Model the subsidy cliff alongside the bracket.

Conversion-averaging across a volatile year

You do not have to convert everything on one day. Because there is no annual conversion limit and no recharacterization (TCJA eliminated the undo), you can split a conversion into tranches across a volatile year and catch multiple low points — the conversion equivalent of dollar-cost averaging.

1. January dip: convert $40,000 when the index is down 18%.
2. March selloff: convert another $40,000 when it drops to down 25%.
3. Year-end true-up: in Q4, once your full-year income is known, convert a final tranche sized to fill the 22% bracket exactly — no more, no less.

Tranching does two things at once: it averages your conversion price across the year’s lows, and it lets you target the $206,700 MFJ bracket ceiling precisely instead of guessing in January. The conversion deadline is December 31 of the tax year — not April 15 — so your final tranche must clear by year-end.

What most people miss: you are not betting on the bottom

The most common reason people skip a down-market conversion is fear that the market falls further after they convert. That fear misreads the trade. You are not trying to call the exact bottom. You are moving shares from a taxable wrapper to a tax-free wrapper at a moment when the toll for crossing is cheap.

If the market keeps dropping after you convert, you paid tax on dollars that later shrank — a genuine opportunity cost, but a far smaller one than people imagine, and recharacterization is gone so you cannot reverse it. Compare the two real outcomes. Convert at down-20% and the market recovers: you captured a $40,000 rebound tax-free. Convert at down-20% and the market drops another 10%: you paid tax on $160,000 that briefly became $144,000, but every future dollar of eventual recovery — back to $200,000 and beyond — is still tax-free inside the Roth. The downside is a timing imperfection; the upside is permanent tax-free growth on the entire recovery.

The defense against bad timing is not waiting — waiting forfeits the discount entirely. The defense is conversion-averaging, so no single day sets your whole tax bill.

When a down-market conversion is the wrong call

The math flips against you in a few specific situations. Run these checks before you convert:

• You cannot pay the tax from outside funds. If the only way to cover the bill is to raid the IRA, the strategy loses most of its value — and triggers a 10% penalty under §72(t) if you are under 59½.
• You expect a much lower bracket soon. If you are retiring next year into the 12% bracket, converting now at 22% or 24% may cost more than waiting, even with the price discount. Compare the conversion rate to your expected future rate.
• The conversion spikes IRMAA or kills an ACA subsidy. A surcharge or subsidy clawback can swamp the price discount. Size the conversion to stay under the relevant MAGI threshold.
• You will need the converted dollars within 5 years. The Roth conversion 5-year rule means converted principal withdrawn before 5 years can face a 10% penalty if you are under 59½. The Ruizes are 61, so this does not bind them, but younger converters should plan around it.

The conversion 5-year clock deserves its own beat because it confuses even experienced converters. Each conversion starts its own 5-year clock on January 1 of the year you convert, and that clock governs only whether you can withdraw the converted principal penalty-free before age 59½. For the Ruizes at 61, the clock is irrelevant — once you are 59½, the 10% early-withdrawal penalty under IRC §72(t) simply does not apply to anything, including freshly converted dollars. A 45-year-old doing the same down-market conversion, by contrast, would need to leave the converted $160,000 untouched until 2031 (the start of the year five tax years later) to pull it out without a 10% hit. The separate §408A 5-year rule on earnings — the growth, not the principal — runs from your very first Roth contribution or conversion and is usually long satisfied for anyone who opened a Roth years ago. Because both clocks favor people already past 59½, a down-market conversion is cleanest for the near-retiree cohort the Ruizes belong to.

Key takeaways

• A Roth conversion is taxed on the dollar value moved on conversion day. A 20% drop on a $200,000 IRA means you convert at $160,000 and pay tax on $160,000 — about $8,800 less at the 22% bracket for the identical shares.
• The $40,000 rebound back to $200,000 grows tax-free inside the Roth, provided you meet the 5-year rule and are 59½+ (IRC §408A). You captured the recovery on the tax-free side of the line.
• Always pay the conversion tax from outside taxable funds. Withholding from the IRA under 59½ triggers a 10% §72(t) penalty and permanently shrinks your tax-free base.
• A conversion stacks on your ordinary income. Watch the 2026 22% ceiling ($103,350 single / $206,700 MFJ), IRMAA surcharges (MFJ $206K threshold), and ACA premium credits.
• Use conversion-averaging — convert in tranches across a volatile year — so no single bad day sets your whole tax bill. The deadline is December 31, not April 15.

The decision lever is timing plus funding: convert while the price is depressed, and pay the tax from outside cash so every converted dollar stays inside the Roth to capture the recovery tax-free.