By Andy Ives, CFP®, AIF®
Dollar cost averaging is a tried-and-true investment strategy that has existed for decades. Using this technique, an investor divides up their entire amount to be invested and makes smaller periodic purchases over a desired time. The goal of dollar cost averaging is to minimize the potential volatility of a single large investment. Essentially, dollar cost averaging seeks to reduce the possibility of making a big purchase just before the value drops.
Example: Roger has $10,000 and wants to invest in a mutual fund. Roger is unsure what the market’s direction will be over the next few months. To avoid the possibility of investing the full $10,000 all at once and then having the market immediately drop, Roger elects to dollar cost average. He invests $1,000 per month into the mutual fund over the next 10 months. This way, as the markets rise and fall, he can “smooth out” his entry points into an average.
This same technique can be used with Roth conversions. While you don’t technically “buy” a Roth conversion like a mutual fund, you do have an entry point into the Roth. This entry point determines how much additional income you must include for the year (the conversion amount). Extra income equals the potential for more taxes. As such, converting to a Roth when your account value is at its lowest point is optimum. Buy low and sell high, right?
But no one can accurately predict the markets. Where is the bottom? When is “low” low enough? To make matters worse, a Roth conversion cannot be reversed. There is no longer any opportunity to recharacterize. The income is locked in.
Example: Eager Eddie has a $2 million IRA. He is excited to move all those dollars into a Roth. Eager Eddie does a full Roth conversion in mid-February 2020 when the Dow Jones is over 29,000, locking in $2,000,000 of income. Just one month later, the DJIA has plummeted to below 19,000. Eager Eddie’s Roth IRA is now only worth $1.5 million. Had he waited to convert, he could have saved the taxes due on $500,000 of income.
Dollar cost averaging a Roth conversion can help avoid such timing issues. Once again, no one can predict the bottom. So, to smooth out the entry points of a Roth conversion, why not do a series of smaller partial conversions? After all, there is no limit on how many a person can do.
Example: Patient Patty wants to convert her IRA to a Roth in 2020. She asked her financial advisor to convert 1/12 of her account each month. Her advisor did just that in January and February. In March, when the market dropped, Patty and her advisor saw an opportunity. They accelerated the conversion process and did three months’ worth of conversions in March alone. The market was still low in April, so they did two more months of conversions. With the market recovering, Patty went back to her monthly “dollar cost averaging” Roth conversion strategy. By employing this technique, Patty converted more dollars at low prices and ultimately saved taxes.
Dollar cost averaging isn’t perfect, especially if the market is a rocket ship, but it can be a long-term, practical approach to reducing the “timing risk” of a single large Roth conversion.
Dollar cost averaging is a tried-and-true investment strategy that has existed for decades. Using this technique, an investor divides up their entire amount to be invested and makes smaller periodic purchases over a desired time. The goal of dollar cost averaging is to minimize the potential volatility of a single large investment.