2020 has been a challenging year, but it has also provided some unique tax and retirement planning opportunities. Depending on your financial situation, one possibility might be to convert some or all of your Traditional IRA to its cousin – the Roth IRA.
The differences between a Traditional IRA and a Roth IRA
The IRA (Individual Retirement Arrangement) was established in 1974 as part of the Employee Retirement Income Security Act (ERISA). The primary legislative goal was to provide a tax-advantaged retirement plan for employees when a pension was not an option. In 1997, the Roth IRA was introduced as part of the Taxpayer Relief Act. Named after U.S. Senator William Roth, the purpose of the Roth IRA had more to do with tax revenue concerns. This is how they work:
- The Traditional IRA receives a tax deduction when contributions are made; the Roth IRA does not.
- The Traditional IRA is taxed as ordinary income when money is withdrawn, but Roth IRA withdrawals are tax-free.
- Those over age 72 must take Required Minimum Distributions (RMDs) from a Traditional IRA; Roth IRAs do not require them because no “tax bill” is due.
Their differences make both retirement plan accounts useful in different financial situations. This year it is the Roth IRA receiving all the attention.
A Roth Conversion can be an advantage in any given year if:
- You think your tax rate will be significantly higher in the future than it is today. The expectation is that it will save you money paying lower taxes today in return for withdrawing monies tax-free in the future.
- You do not need or want income from RMDs. The smaller the account balance of the Traditional IRA, the less you will be forced to draw each year.
- You anticipate a “golden” window of lower income between retirement and RMDs. Many taxpayers who retire in their 60s have lower tax rates until they reach their maximum Social Security age of 70 and also must take RMDs at age 72. This can be an opportunity to take partial “fill-up-the-tax-bracket” Roth Conversions when it would not make sense otherwise.
- You can pay the conversion taxes with outside dollars. Using retirement funds reduces the size of the Roth conversion, which will make a difference over the years as you miss out on some of the powerful growth of compound interest.
- You have at least a 10-year time horizon. Deciding whether to do a Roth Conversion is basically a break-even analysis. When you convert a Traditional IRA to a Roth, you are betting that the upfront ordinary income taxes you trigger when you withdraw from the IRA will be outweighed by the future benefit of the tax-free growth and withdrawals from the Roth IRA. You need time for the investments to grow to enjoy this benefit fully.
So, this brings us to the 2020 Roth Conversion. There has been a lot of recent financial press about this tax strategy because this has been such an unusual year.
A Roth Conversion may be particularly advantageous this year because:
- The SECURE Act eliminated a popular estate planning strategy — the “stretch” IRA. Instead of stretching the required withdrawals over their lifetime, non-spouse beneficiaries now have only ten years to fully distribute and pay taxes on the account. This can be problematic for heirs during their earning years. For a large Traditional IRA, for example, they will either have to spread out taxable withdrawals over a relatively short period of time, or take a hefty tax hit at the end of the ten years. With a Roth IRA, on the other hand, your heirs can allow the account to grow for the full ten years and then make the entire withdrawal – all tax-free.
- The CARES Act suspended IRA Required Minimum Distributions. If you don’t need the cash, not taking your RMD will reduce your taxable income this year.
- COVID-19’s effect on the economy has also reduced other sources of income. Many have seen reductions in earned income this year. For those who own real estate, rental income might be lower, and people who took advantage of the market drop to realize losses in their portfolio might also have reduced capital gains income. Interest rates are also at historic lows, which means less taxable interest income. Reduced income generally allows for more flexibility in doing Roth conversions.
- Tax rates are at historic lows. Taxes do seem likely to go up in the future, given the cost of the large federal bailouts and the size of the current deficit.
What to Look Out For:
There are clear advantages for some individuals to consider a Roth Conversion, but it is wise to consult a financial advisor or tax professional, and possibly an estate planning attorney. As opposed to the pros mentioned above, there are a few cons as well:
- Recognizing taxes now may cause you to incur the additional Medicare surtax on your investment income or prevent you from being able to take advantage of the Affordable Care Act’s healthcare premium subsidies.
- If you are planning to move to a state that doesn’t tax retirement distribution income, it can make a Roth conversion less attractive.
- Or if you have charitable intent, leaving a Traditional IRA to charity avoids the tax bill, making a conversion unnecessary.
As you can see, this is a complicated issue, so getting the opinion of a professional can help you decide whether this strategy is indeed a great one for you.