Consider a Roth conversion for 2020


2020 has created a sense of urgency about lots of things, including people’s health, finances, education … practically everything. However, it may also have created a good time for people to rethink their tax planning, and it may have created an opportunity for you to do a Roth conversion.

Why now? A few reasons:

1. Federal legislation has waived required minimum distributions this year. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, waived required minimum distributions (RMD) that retirees would normally be required to take from their retirement accounts. Since RMDs are taxed as ordinary income, not taking an RMD this year would mean less income and potentially lower tax brackets.

2. Unfortunately, many people will have lower than normal income in 2020 because of the pandemic, and therefore fall into lower tax brackets. In an attempt to make lemonade out of lemons, this could actually be a good thing for a Roth conversion.

3. The Tax Cuts and Jobs Act (TCJA) with its lower tax brackets and larger standard deduction, will go away in 2025 unless new legislation is passed to extend it. Our national deficit and debt have exploded this year and we feel it is likely that taxes eventually go higher. So, if you convert in 2020, you’ll pay today’s lower tax rates on the income triggered by the conversion and avoid the potential for higher future rates on the post-conversion income that will be earned in your Roth IRA account. In effect, the Roth conversion strategy insures you against future tax rate increases that would otherwise hit withdrawals coming from your traditional IRA balance plus future account earnings.

4. Another reason to consider a Roth conversion is that the SECURE Act (passed in late 2019) did away with stretch IRAs, which now forces those who inherited Individual Retirement Accounts to remove their funds within 10 years rather than stretching out the distributions over time, a strategy that allowed lower taxes and more favorable estate planning. This is another reason retirees should try to get money out of taxable accounts at lower brackets. Inherited Roth IRA’s do not require RMDs and distributions can be withdrawn tax-free. The key to think about when evaluating a Roth conversion is higher tax rates you can avoid in the future. For example, pulling money out of an IRA and converting that into a Roth IRA while paying 12% in Federal taxes is a much better deal than pulling money out of an IRA in later years and paying 24% in Federal taxes. Figuring out the optimal Roth conversion amount will take some planning because you usually will want to convert the amount to get to the edge of the next tax bracket. This requires calculating what your total income will be for the year.

It can also be helpful if you have brokerage (after-tax) account assets that you can use for income and for paying the taxes on the conversion. Brokerage account assets can be used for monthly living expenses to make your income “on paper” appear lower. Brokerage account assets can also be used to pay the taxes on the Roth conversion so you can convert the full amount and not have to have taxes withheld on the conversion. This allows you to get more assets into the Roth IRA which allows for more tax-free growth over time. It is important to note that there can also be good reasons NOT to do a Roth conversion. Since Roth conversions are considered ordinary income, you could increase your income tax rate so that you are now paying taxes on capital gains and qualified dividends. You might also increase your income tax rate so that you end up paying more tax on your Social Security and/or increased Medicare premiums. Don’t disregard other tax benefits that the Roth conversion may disallow. Bottom Line: From a tax planning standpoint this could be a great year to consider a Roth conversion. Managing the tax impact of a Roth IRA conversion requires careful analysis, so you’ll want to talk to us and/or your tax advisor before pulling the trigger, just to make sure you’ve considered all the relevant factors. Roth conversions must be completed by December 31st to be included in that year’s taxable income so now is the time to start your analysis.

- Brett

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