There is no doubt that the COVID-19 pandemic has disrupted almost every aspect of our lives. From business shutdowns, to school closings, and orders to stay “safe at home,” we are currently facing challenges we certainly did not foresee.
As with any difficult change or transition in life, there lies opportunities for growth. Families are slowing down and coming together. Businesses are finding new and creative ways to provide products and services, and individual investors are exploring alternative avenues for investment such as Roth IRA conversions. Declined markets present an opportunity to perform a Roth conversion due to the nature of the Roth IRA’s tax structure.
What is a ROTH IRA Conversion?
A Roth conversion refers to the transfer of an Individual Retirement Account (IRA), either traditional, SIMPLE, or SEP-IRA, into a Roth IRA. Roth IRAs are attractive investment vehicles because they offer tax-free growth and withdrawals. Because taxes are paid on the money upon contribution, it is not taxed when taken out in retirement. This is especially beneficial for individuals who believe they will be in a higher income tax bracket when they begin making withdrawals.
Unlike traditional IRA accounts, Roth IRAs do not require individuals to take Required Minimum Distributions (RMDs) during their lifetime. The account continues to enjoy tax deferred growth and ultimately, tax free distributions. This allows for strategic tax planning (and ultimately saving) in retirement, but can be a wonderful legacy gift for heirs to receive if the funds aren't used during the account owners' lifetime.
Why perform a conversion and not just open a Roth IRA account up front?
Roth IRAs have many incentives, but with those perks come restrictions. Income and contribution limits that are determined by your annual tax filing status.
Roth IRA Income and Contribution Limits 2020
If you are single, married filing separately, or filing as head of household, you can contribute up to $6,000 ($7,000 over age 50) to a Roth IRA if your modified adjusted gross income (MAGI) is less than $124,000. Your contributions will be reduced if you make more than $124,000 and you become ineligible if you earn more than $139,000.
If you are married filing jointly or a qualified widow(er), you can contribute up to $6,000 ($7,000 over age 50) to a Roth IRA if your MAGI is less than $196,000. Your contributions will be reduced if you make more than $196,000 and you become ineligible if you earn more than $206,000.
If you are married filing separately and you did live with your spouse at any time during the year, you can contribute a reduced amount to your Roth IRA if your MAGI is less than $10,000.
These income limits disallow many investors from opening a Roth IRA. However, high-income earners and other ineligible contributors can take advantage of this tax-free investment vehicle by performing a conversion. Conversions can be made annually without limit to the amount converted. The converted funds are taxable income upon rollover so the amount must be considered in your tax-planning strategy.
Why are Down Markets a Smart Time to Perform a Roth IRA Conversion?
In the midst of the COVID-19 financial crisis, most investors’ portfolios have taken a hit and are sitting at a reduced value. For example, a couple with a million in retirement savings in 2019, may now be looking at closer to $800,000 in savings. These depressed asset levels mean that performing a Roth conversion now would:
- Allow you to pay income taxes at today’s rates on an asset that will likely increase in value over time
- Pay taxes on a lower conversion amount
- Increase your principal for tax free growth
Keep in mind that a Roth conversion is not a simple process and should only be performed with the help of a trusted financial advisor. It is also a process that cannot be reversed, so you’ll want to get an objective opinion on how this strategy fits into your overall financial plan.
Interested in learning more about how to protect your income in a down market? The Certified Financial Planner®Professionals (CFP®s) at Northstar Financial Planning can help you decide which strategies align with your long-term goals and risk tolerance level to design your model lifestyle. Schedule a complimentary Get Acquainted call to meet us over the phone and discuss how we may be of service.