Utilizing a Roth conversion strategy to lower one’s assets in a tax-deferred account is not a novel idea. Financial advisors and planners typically would recommend their clients employ this technique in two scenarios: 1. When they are presently in a lower tax bracket and anticipate a higher one in the future, or 2. When they want to decrease their future required minimum distributions with the goal of preserving a future lower tax bracket. Recently, you have likely heard a lot more about Roth conversions whether it be from your team at Becker Capital, news outlets, or maybe even a friend or neighbor. In this post we will answer the question of ‘why now?’, illustrate the basics of a conversion and help you determine if utilizing this strategy is appropriate for you.
As a reminder, below are the main differences between a Traditional and Roth IRA:
Regardless of the global pandemic and current economic environment, Roth conversions would still be a topic of conversation in 2020. IRA rules had two significant changes take place recently thanks to the SECURE Act, which became law on December 20, 2019. The first change impacted the age Required Minimum Distributions (RMDs) begin. Previously, when an IRA owner reached the age of 70 ½, they would need to begin their RMDs. That age has now been adjusted to 72, meaning that investors have at least one more year to make a conversion without also having to take their RMD. Second, when an IRA is inherited by a non-spouse, non-eligible beneficiary, they no longer have the option to stretch the RMDs over their own lifespan. Instead, they have ten years to withdraw the entirety of the account. If the beneficiary is a high-earner or on the cusp of a higher tax bracket, this can result in the individual paying additional taxes with little opportunity for tax efficient planning. Furthermore, with the passing of the CARES Act in March 2020, IRA owners can now waive their 2020 RMD. If they choose to do so, they are effectively lowering their taxable income, potentially preserving a lower tax bracket. This confluence of events has created an opportunity for those wanting to take a distribution from their IRA but not necessarily needing to use the funds for their expenses, resulting in ample reasoning to consider a full or partial Roth conversion this year. All of this not to mention that we are experiencing some of the lowest tax rates in history.
Converting all or part of a traditional IRA to a Roth IRA is a straightforward process. An individual can direct the rollover to an existing Roth IRA, or they can open a new Roth account to receive the funds. Taxes must be paid during the year of conversion and it is highly advised that they be paid from an outside source, not from the amount being converted, to allow the full amount to grow tax-free. Once the funds are in the Roth IRA, they can be invested and will grow tax-free until the owner decides to withdraw them (after age 59 ½). There are no RMDs from a Roth and this ultimately results in future RMDs from a traditional IRA to be lower, thereby reducing future taxes.
There are also significant estate planning benefits to a Roth conversion. As mentioned previously, if IRA assets are bequeathed to a non-spouse, the beneficiary may have only ten years to withdraw all IRA assets. Recall that Traditional IRA assets are distributed at ordinary income tax rates, while Roth IRA distributions are not taxed at all. When you think about your beneficiary potentially inheriting during their highest income earning years, the tax impact to them can be significant.
Is It Appropriate for Me?
If you answer yes to any of the following questions, we recommend that you reach out to your portfolio manager or planner to discuss your specific scenario and options:
- Have you chosen to utilize the CARES Act provision to forgo your 2020 RMD?
- Do you anticipate being in a higher tax bracket in the future?
- Are you currently in a low tax bracket?
- Do you have tax-deferred assets in excess of $500k?
- Do you anticipate leaving some of your tax-deferred assets for your heirs?
Although this year has been filled with substantial uncertainty in all areas and aspects of life, we are also seeing avenues of opportunity and potential, especially from a financial planning perspective. By being proactive and implementing thoughtful planning, 2020 does not have to be a year that got away. If you have questions specifically about Roth conversions or if you would like to review your financial plan, consider reaching out to the Becker Wealth Planning Team. We are here to help and will work closely with your CPA to review your specific tax situation to provide you with peace of mind.
With the recent IRA rule changes and our low tax rate environment, this is a great time to talk to your financial professionals about possible Roth conversion strategies for 2020 and beyond.