The year is 2020. A global pandemic has swept the nation and a highly controversial presidential election looms on the horizon. The market fell significantly in Q2 and has been highly volatile ever since. So, why could now be the right year to take advantage of a Roth IRA conversion?
Essentially, three conditions unique to this year could make a conversion more appealing: the waiver of Required Minimum Distributions under the CARES Act, the volatility in the stock market, and the possibility that you may have earned less income this year than in year’s past.
Of course, there are a number of conditions to understand in order for you to decide if a conversion in 2020 would be advantageous for you.
How Roth IRAs and Traditional IRAs Differ
The core difference between a Roth IRA and a traditional IRA is when taxes are paid to the IRS—up front or on the back end. With a traditional IRA, taxes are paid on funds upon withdrawal—typically in retirement. With a Roth, taxes are paid upon contribution. In other words, traditional IRAs offer a tax deduction now, and are taxedlaterupon distribution. Roth contributions are taxed now and withdrawn tax-free later.
Given this information, Roth IRAs make the most sense for individuals who have a significant amount of time before they need to withdraw the money and believe they will be in a higher tax bracket in retirement. Young workers, for example, who have yet to hit their peak earning years may benefit from opening or converting to a Roth.
If you believe you will be in a lower tax bracket when you retire, or already have a hefty tax burden now as it is, your best position may be to utilize the upfront tax deduction of the traditional IRA. However, be aware that portion of your traditional contributions you can deduct from your taxes phases out the higher your income. You’ll want to check the income limits and weigh the merits of each option with your financial advisor before making a decision.
- Withdrawal Rules and Penalties:
Roth earnings can be withdrawn income tax free if you’re at least 59 ½ and have had the Roth open for at least 5 years. The age minimum for penalty-free withdrawal is the same for a traditional IRA, 59 ½ , but you are required to begin withdrawing from your traditional IRA at age 72 in what are known as Required Minimum Distributions (RMDs). Both accounts incur a 10% early withdrawal fee.
Your first RMD must be taken by April 1 of the year following the year you reach age 72 and every year thereafter by December 31. Your RMD is calculated by dividing the value of your IRA by a life expectancy factor determined by the IRS. Of course, you can always withdraw more than your RMD, but it will be taxed as ordinary income in the year of withdrawal. RMDs are deemed “required,” because there is a 50% penalty on the amount you should’ve withdrawn if you do not do so by the deadline.
- Income thresholds:
Roths are attractive savings vehicles for their ability to provide tax-free growth and their absence of RMDs; however, there is a catch. Your eligibility to contribute to a Roth IRA is based on your income level. Not everyone is eligible to open one of these accounts. In 2020, if you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $139,000 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $206,000.
There are no income thresholds to open a traditional IRA. It is for this reason that many high-income earners who want to take advantage of a Roth IRA, will perform a conversion. This involves converting all or some of your traditional IRA money to a Roth. This “back door” approach, as it were, allows high-income earners to take advantage of the Roths benefits.
Converting is a Taxable Event
Converting funds from a traditional IRA into a Roth IRA is a taxable event. The key concern, then, is whether or not you will pay taxes at a lower rate today at conversion or later on assuming you left your money in the traditional IRA and took your regular distributions later in life. For example, paying the taxes today on $100k at 24% rate, would be significantly less then paying taxes on $800,000 if the account were to appreciate as expected over time.
Of course, no one can predict the future tax rates; but, what we do know is that in 2025, the lowered federal tax brackets under the Tax Cuts and Jobs Act will expire and will go back up if Congress doesn’t pass new legislation. That means someone who falls into the 24% tax bracket today, could feasibly fall under the 28% tax bracket when this current provision expires. This is a convincing argument for a conversion—paying the taxes now while you are in a lower tax bracket.
Why a Roth May Be More Appealing in 2020
Essentially, the taxes owed for a conversion may be more affordable in 2020 given the following circumstances:
1) No RMDs:
Under the CARES Act, retirees have been permitted to skip taking their RMD for the year 2020. In fact, they can even replace an RMD if they already took it. Retirees who don’t need their RMD might want to consider converting the amount equal to their waived distribution.
2) Market Lows:
Thus far, the 2020 markets have proven to be tightly tethered to the Coronavirus pandemic and we’ll likely experience several bouts of volatility as we approach the presidential election in November. If your retirement savings portfolio has taken a significant hit this year, your conversion will incur less tax than it normally would. In other words, you may be able to convert more this year while incurring the same or less tax than you would in other years where the value of your account is higher.
3) Lower 2020 Income:
If you are one of the millions of Americans whose income took a hit due to the COVID-19 pandemic this year, you may want to pay conversion tax while your ordinary income tax is lower. A lower income tax liability may be enough to offset the conversion tax and make the strategy worthwhile.
Seeking the Guidance of a Trusted Professional
Of course, the decision to convert to a Roth is a major one and should not be made in isolation. You’ll need to examine your current and estimated future tax environments as well as your other available resources for retirement income to start. You will also want to consider the legacy rules of each account if you don’t intend to use all the funds in your IRA before your passing. Consult with your financial advisor to help you decide if a Roth conversion fits into your retirement plan.
We understand that the financial planning puzzle can be complicated. It can be difficult to see how all the pieces will fit together on your own. We also know that many individuals and families will avoid financial planning for this very reason, which is why we are here to help.
Our goal is to help you reach yours, whether that means performing a Roth conversion or helping you decide how you’ll spend your time in retirement. We focus on the big picture and the whole person, not just the numbers on the page.
If you think our firm sounds like a good fit for you, please contact us today for a complimentary "Get Acquainted" meeting. We look forward to getting to know you.