Roth Conversion 2020, yay or nay?

Roth Conversion 2020, yay or nay?

The COVID-19 pandemic has shaken up nearly every aspect of American life. To say it has been a difficult time would be an understatement. 

However, difficult times may open doors to new possibilities. Businesses are changing their ways of operating, and individuals are exploring new avenues for financial planning. It may be time for you to consider some opportunities that are more attractive now than they may have been only a few months ago.

What is a Roth IRA Conversion?

A Roth IRA conversion refers to the complete or partial transfer of the assets contained within an Individual Retirement Account (IRA), either Traditional, SIMPLE, or SEP-IRA, into a Roth IRA. With this type of move to a Roth IRA, you pay tax on the money in the year of the conversion, and effectively when it transfers into the Roth IRA account.  When the short-term result is an increase your current year income tax liability, what on earth would make you want to consider this?

The most sought after benefit is that since these converted funds are taxed as they go into the Roth IRA, any future qualified distributions will qualify for income tax-free distribution status.  Specifically, this means that you need to allow the tax-free growth portion of the assets to remain in the account for a minimum of five years from the date of the conversion, or until you reach at least age 59 ½, whichever comes later.  But once those two stipulations have been met, all distributions that are taken from your Roth IRA are distributed to you with no income tax liability.  (It should be noted that tax rules are constantly changing, and it is possible that future legislation could diminish the tax-free status of Roth IRA distributions.)

A second benefit to having your money in the Roth IRA is that, unlike a Traditional IRA, you currently are not obligated to take Required Minimum Distributions (RMDs) after you reach age 72.  This is especially powerful whether looking for ways to minimize your taxable income in retirement, particularly when factoring in Social Security or Pension income, or trying to maximize the asset base that you wish to pass to your beneficiaries.  It should be noted that after your death RMDs would be required to any non-spousal beneficiaries, as outlined in the SECURE Act, but that those distributions too would come out free of income tax burden.  By integrating your estate planning attorney in on this discussion, we can create the most effective combination of income and estate tax avoidance to help you to magnify the legacy that you leave.

Another interesting planning point is that if you are already taking RMD’s from your IRA accounts, you should remember that 2020 is a unique year.  As a response to the COVID-19 pandemic, The CARES Act included a provision that suspends the Required Minimum Distribution (RMD) requirement for any American for the 2020 tax year.  With this temporary removal of income that is forced onto your tax return, there is a unique opportunity for Americans of RMD age to convert their taxable IRA assets, or at least a portion of them, to a Roth IRA. (Be aware, however, that this option does not apply to non-spousal Beneficiary IRA owners who are taking RMD’s.)

Why Consider a Roth Conversion in 2020?

In the face of the market downturn after the COVID-19 outbreak, you may be in a unique financial situation. For example, suppose you have an IRA account that was worth $400,000 before the downturn, but it is currently worth $300,000.  By executing a conversion prior to a market rebound, you are effectively transferring the same number of shares of a given security for a portion of the tax liability.  If the intention for those assets is to remain invested in a similar manner, why not consider allowing the recovery growth and all future gains in a non-taxable account?

Furthermore, it is quite possible that your income has also decreased, potentially putting you into a lower marginal income tax bracket. If you are finding that your projected tax bracket is significantly lower, you may decide that incurring the tax burden today at a known tax rate is far more attractive than continuing to grow your assets with an unknown future liability looming down the road.  The devil that you know is often less scary than the devil that you do not.

In short, a lower current taxable income combined with a reduced account value could create an attractive scenario that allows for a more proactive approach to your future tax and estate planning.

Some Factors to Consider Before a Conversion

While this may be a good time for you to consider converting to a Roth IRA, remember that there is no turning back once you do. While there once was a time that you could change your mind and “recharacterize” (translation: Undo!) a Roth IRA Conversion prior to year-end, the Tax Cuts and Jobs Act of 2017 decreed that Roth conversions could no longer be undone.  The lesson, plan carefully and move confidently, for there is no going back.

A second item is that a conversation must occur with your CPA or income tax professional prior to executing the conversion.  Because a Roth Conversion increases your income in the current year, there could be situations in which all of the potential benefits of the process are negated by unforeseen changes in your tax situation.  For example, increases in your Adjusted Gross Income (AGI) could:

  • Reduce or disqualify a college-aged dependent for Financial Aid by increasing your AGI on their FAFSA,
  • Reduce or eliminate your benefit to tax credits or incentives, like the Child Tax Credit or American Opportunities Credit, based upon a higher AGI, or,
  • Reduce or eliminate the ability to receive a CARES Act Stimulus payment(s) in 2020 as a result of a higher income that exceeds the threshold.

Finally, there are considerations that should be addressed with regard to how you will pay the income tax burden on a Roth IRA Conversion.  If you are not age 59 ½ or older at the time of the conversion, it is imperative that you have funds that are outside of your IRA that are available to settle the income tax bill that will come due.  Consider this, if you withhold a portion of your converted amount and that is withheld and utilized to settle your conversion tax bill, it has the same effect as a premature IRA distribution.  As such, that withheld amount becomes taxable and will include premature distribution penalties, and that scenario should be avoided at all costs.

A Roth IRA conversion is a complicated process, but if you are interested in exploring this option, we would encourage you to give our team a call to talk though the specifics of your situation. Our team has the experience and training to help you to determine whether this is an opportunity worth considering, or whether the current tax costs outweigh the benefits. 

Please keep in mind, this letter is for information purposes only and is making an assumption on an IRA account’s value and applying a hypothetical drop in earned income. We recommend that you contact your tax or legal professional before modifying your retirement investment strategy.

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