2020: The Year of the Roth Conversion

As a former philosophy minor, I believe that there are yin and yang forces at work in the world.  This Chinese concept of dualism (negative-positive, dark-bright) postures that these contrary forces may actually be complementary.  Perhaps it is a result of self-isolation, but I have been looking for the positive outcomes to offset all the negativity in our lives.  In other words, what opportunities present themselves so that we can benefit from the situation at hand?  We have the following economic factors currently:

  • A market correction that has lowered account values (yin)
  • Historically low federal tax rates courtesy of the Tax Cuts & Jobs Act (yang)
  • Suspension of Required Minimum Distributions from IRA’s and retirement plan accounts in 2020 from the CARES Act (yang)
  • Depressed income for many working Americans because of the COVID-19 crisis and the nationwide shutdown (yin)

The negative factors (yin) and positive factors (yang) at work present an enormous opportunity to optimize Roth IRA conversions.  A Roth conversion allows IRA owners to convert traditional (pre-tax) IRA contributions into after-tax Roth assets. Because Roth’s must be funded with after-tax dollars, the entire amount of the conversion will be added to the owner’s taxable income in the year of the conversion. We have written extensively about Roth conversions and backdoor Roth strategies here.

Should I do a Roth Conversion

Converting funds when the market is low makes sense as there will be a lower tax cost to do so.  Additionally, the funds will likely be invested at bargain prices and the future increase in value will be inside the tax-free wrapper of the Roth IRA.  Our present tax rates are at historic lows and likely to trend higher over time, particularly given the recent enormous bailout.  Retirement funds that are converted now are likely to be taxed at unprecedented low rates compared to the likely tax rates in 6-10 years.  For those over the age of 70, the suspension of the RMDs in 2020 further sweetens the pot.  These individuals will have a one-time opportunity to convert some of their retirement funds this year without the additional tax burden of their required minimum distribution.  Similarly, for those who are employed or self-employed, 2020 could be a year of reduced income and therefore, lower tax rates which would make Roth conversions more attractive.

Advantages of Roth IRA

Remember that there are significant differences between Roth accounts and pre-tax “traditional” accounts. Whether or not these differences are advantageous to you depends entirely on the specifics of your personal situation. The rules governing income taxation and tax penalties for retirement accounts are very complicated and we strongly recommend seeking the advice of a CERTIFIED FINANCIAL PLANNER™ and/or CPA prior to making contribution, withdrawal or conversion decisions. That being said, the biggest benefits of doing a Roth conversion are as follows:

  • Distributions from Roth IRAs where the contributions or converted assets have been held for more than five years and the original owner has either reached age 59 ½, died, or become disabled are always tax and penalty free.
  • After a five-year holding period, withdrawals up to the amount of the conversion can be made income tax and penalty free regardless of age.
  • There are many other situations in which tax and penalty may be avoided.
  • Roth IRAs never have RMDs. This is a major benefit for those fortunate enough to not need distributions from retirement accounts for living expenses. This benefit extends to spousal Roth IRA beneficiaries. Do keep in mind that non-spousal beneficiaries need to liquidate inherited Roth IRAs within 10 years of the date of death

The SECURE Act of 2019 drastically changed the liquidation timeline for inherited IRAs. Previously, non-spousal beneficiaries could “stretch” their inherited IRA out by taking RMDs based on their life expectancy. Thus, the younger the beneficiary, the longer taxes could be deferred. The SECURE Act eliminated this “stretch” IRA strategy, requiring accounts to be fully liquidated within 10 years of the owner’s death. Spousal beneficiaries do not face this requirement. Roth accounts are often used as part of a comprehensive estate planning strategy, but the viability of the Roth element varies according to each client’s specific situation and estate planning goals.

Roth IRA Conversion

In a best-case scenario, you will want to pay for the taxes with money outside of the IRA and limit your conversion amount to an acceptable marginal tax rate (possibly splitting the conversion over multiple years).  As a reminder, the IRS no longer offers taxpayers the ability to recharacterize your conversion after the fact so consider all factors fully before you act.  Consider your personal situation carefully, but 2020 may prove to be an optimal time to consider a Roth IRA conversion.