2020's Unique Opportunity:
The Roth IRA Conversion
What You Need to Know
This year has been extraordinary in many ways. Stock market volatility, COVID-19, and a presidential election. Not every event this year has been optimal, but there is a silver lining for some in that 2020 has provided a unique opportunity to save some taxes by utilizing a Roth IRA conversion. Several factors have come together in 2020 that make a Roth conversion an excellent move for many savers. These factors include:
- The SECURE Act accelerated the required timeframe for non-spouse beneficiaries to withdraw money out of inherited retirement accounts.
- The CARES Act suspended 2020 Required Minimum Distributions (RMDs) from retirement accounts for those age 72 or older.
- The negative impact of COVID-19 on the global economy caused widespread layoffs and furloughs of employees nationwide.
The SECURE Act
When the SECURE Act became law in late 2019, the rules for non-spouse beneficiaries of inherited retirement plans changed. Previously a non-spouse beneficiary could stretch out distributions from an inherited IRA over his or her lifetime; now, this beneficiary (with limited exceptions) must withdraw the entire account within 10 years after the original owner's death. This accelerated timeframe means paying taxes on this money sooner, leaving less time for the investments to continue to grow tax-free after your passing.
A Roth conversion can help in situations like these where the original owner is better positioned to shoulder the tax burden than their heirs.
For example, suppose Mom and Dad are retired with a moderate fixed income and IRA holdings of $250,000. This likely means they are in a lower tax bracket than their working-aged children. If they undertake systematic Roth conversions over several years (keeping them in the 22% tax bracket), at their passing, their heirs would receive this money tax-free rather than paying taxes at their higher tax bracket. They would still have to withdraw this money within the 10-year timeframe but will not have to pay taxes on any distributions.
The CARES Act
Part of the CARES Act waived Required Minimum Distributions (RMDs) for retirement savings accounts for 2020. If you didn’t need the money for life expenses anyway, you might look at 2020’s RMD waiver as a gift – where you can enjoy a year with a slightly lower income tax bill, since you’re not required to take the distribution. If there’s no distribution, your income will be lower, as will your tax bill.
However, if you’re already accustomed to the tax bill from prior years’ RMDs, why not take this opportunity to withdraw what would have been your RMD and convert that money over to Roth? Normally, if an RMD is required for a particular year you can’t convert that withdrawal to Roth IRA – only the amounts above your RMD can be converted. But for 2020, you can convert even your first dollar of withdrawal from your IRA.
When Roth conversions may not make sense
Although a Roth conversion can be a powerful tool that can result in some significant tax savings, there are some situations where a Roth conversion may not make sense. Below are important considerations to take before converting your traditional IRA into a Roth account.
Consideration #1: Your Timeline to Retirement
- If you’re retiring within the next few years, you may want to forego a Roth conversion. Why? Because the money you convert into a Roth IRA must stay there for a five-year holding period to benefit from tax-free withdrawals. If withdrawals are made before the five years is up, you could be hit with a 10 percent penalty and/or additional income taxes.
Consideration #2: Your Heirs Are In A Lower Tax Bracket
- If your heirs are in a lower tax bracket than you, or you may be in a lower tax bracket in the future, a Roth conversion might not be the right move for you. You may be better off leaving this money to your heirs as is and have them pay the tax burden at their lower tax rate.
Consideration #3: Your State Income Tax Situation Is Changing
- If you are nearing retirement, you may be considering relocating to a state which may have lower or no state income tax. Some popular retirement destinations with no state income tax include Florida, Washington, Tennessee, and Texas. If you are currently in a high-income tax state, such as New York, New Jersey, or California, you may be better off waiting to pursue a Roth conversion until after you've established residency in your new State.
We are hear to help.
If you’d like to explore a Roth conversion, please call Cherie Andre at (908) 583-8603 or email us at firstname.lastname@example.org to schedule a review today!