You may have a traditional IRA you’ve been thinking about converting into a Roth, but either you never got around to doing it or the timing was wrong because the conversion would have created extra taxable income and a higher tax bill. Guess what? In either case, luck might now be on your side and this could be the right time to make lemonade with a sweet lemon.
If the impact of COVID-19 on your business and finances has resulted in decreased revenue and income, converting a traditional IRA into a Roth IRA now could make conversions an affordable tax cost for this year while also giving you an advantage against the higher tax rates most analysts are expecting to see in the next few years. Before we explore those details, here’s some necessary background.
Roth IRAs offer two advantages … Qualified withdrawals receive tax-free treatment, and they offer an exemption from the Required Minimum Distribution (RMD) rules. Let’s take a closer look at each of these advantages.
Roth IRAs are free of federal income tax, and usually exempt from state income tax as well. In order for a withdrawal to be qualified for tax-free status, the owner of the Roth must have had the IRA for over five years and must either be 59½ years old, become disabled, or deceased. The five-year clock begins on the first day of the tax year in which the initial contribution to the Roth was made. This initial contribution may be either a regular annual contribution or a conversion from a traditional IRA.
Required Minimum Distribution (RMD) Exemption
As you know, at age 72 the holder of a traditional IRA must begin taking RMDs, and these are at least partially taxable if not fully taxable depending on the owner’s circumstances. However, with a Roth IRA, distribution is not required at any age, and the account can remain untouched for the rest of his or her life if desired, even as this asset continues to grow. Because this account can be left undisturbed, it can be a wonderful legacy the owner can leave to heirs.
Should the owner die and leave the Roth IRA to a spousal beneficiary, the surviving spouse inherits the account as though it was his or her own Roth IRA account. This means the account can continue to remain untouched for the rest of his or her life as well, earning tax-free income and gains.
The account can then be passed on to a new spouse, or to a non-spousal beneficiary or beneficiaries. If the Roth IRA goes to a nonspousal beneficiary, the nonspousal beneficiary can leave the account undisturbed for about 10 years after the death of the prior owner. At the end of the 10-year period, the Roth IRA must be terminated with all funds withdrawn.
Consider if This is the Perfect Time for You
There are three reasons why this may be the perfect time for you to convert your traditional IRA into a Roth IRA.
1. Tax Rates are Low. The Tax Cuts and Jobs Act (TCJA) reduced tax rates for 2018 – 2025, but higher rates are likely to return in 2026. There is also much discussion about the potential for increased taxes to help the economy recover because of the COVID-19 health crisis. Shifting your account from a traditional IRA into a Roth IRA now, before new potential taxes are established, means you could preserve more of your wealth by paying lower taxes now rather than higher taxes later.
2. Your Income was Reduced This Year. If it’s likely that your 2020 income will be less this year because of the effect of the health crisis, your federal income tax rate could be lower than usual. If this is the case, you may have a lower tax bill, so it might make sense to switch from a traditional IRA to a Roth IRA now when your tax rate is temporarily lower.
3. Lower Balance in your IRA. Another unpleasantry is that your IRA may have suffered a loss in value because of stock market declines. Depending on how your traditional IRA was invested, your IRA account may have a lower balance. However, a lower balance may translate into a lower tax bill should you convert from a traditional to a Roth IRA. Transferring the money into a Roth IRA now will allow the money to grow tax-free when the market picks up.
This is a good time to take a moment and consider if transferring your traditional IRA into a Roth IRA is an opportune move for you before the year ends. If it is, you could preserve your wealth by mitigating it from the taxation your account might otherwise experience in the future.
As always, consult with your tax advisor for a carefully considered decision on which course is best for you and your unique circumstances.
We hope this blog post about potentially reducing your tax responsibilities by taking advantage of current financial circumstances was helpful and provided some ideas for a discussion with your tax advisor. If you would like to have a conversation with us about your portfolio’s performance, your plans for retirement or other topics that could benefit you and your family financially, please contact us. Thank you!
Joseph M. Maas, CFA, CVA, ABAR, CM&AA, CFP®, ChFC, CLU®, MSFS, CCIM
Synergy Financial Management, LLC
13231 SE 36th Street, Suite 215
Bellevue, WA 98006
This article is for general educational purposes only. Nothing should be construed as individual tax advice. Please consult a tax advisor to see if this information is right for your situation.