Roth IRA conversions have been a popular topic in 2020 especially when the market dropped significantly in the spring with the onset of the COVID 19 pandemic. The markets have rebounded but it is still a good idea to consider a conversion in 2020.
The benefits of a Roth IRA as compared to traditional IRAs can be substantial. Roth IRA distributions, unlike the traditional IRA, can be withdrawn tax-free if certain conditions are met. Qualified tax-free distributions occur when the Roth IRA is held for 5 years (since the conversion or first contribution) AND the owner is one of the following; at least 59 ½, disabled, first-time homebuyer (up to a $ 10,000-lifetime distribution) or is paid to a beneficiary upon the owner’s death. Tax-free income will be beneficial in years with higher tax rates, compared to the lower rates now. The Roth IRA will also grow income tax-free, which is extremely beneficial not only to the retiree but to the beneficiaries of the account owner. Also, unlike traditional IRAs, there are no required minimum distributions during the lifetime.
Regardless of the benefits, in order to determine whether you should convert to a Roth IRA, the conversion cost must be determined. The cost of the conversion is the tax on the fair market value of the IRA when converted less any basis in the IRA. Keep in mind, the entire IRA does not need to be converted, therefore you can determine a specific amount you would like to convert.
It is prudent to note when comparing traditional IRAs to Roth IRAs, that the net return stays the same if tax rates stay the same. The tax advantage compounds over time if tax rates increase. Given our low- income tax environment and with the events of 2020 including the looming elections, it is expected that tax rates will increase sooner rather than later.
How should you plan to minimize the tax effect of the conversion? Since a Roth conversion will increase your gross income, you must look to your other sources of income and how they will be affected.
- Higher income could reduce tax deductions such as the medical deduction or increase the taxation of other income, such as social security income.
- Some credits, like the child tax credit and education credits, can only be claimed if your income is under a threshold. Higher income could reduce or even eliminate these dollar-for-dollar tax credits.
- Even nontax factors such as Medicare premium charges and property tax exemptions can be affected by an increase in taxable income.
- Other considerations regarding the tax effect of the conversion is the effect on the lower capital gains rates. Note, that there is still a 0 percent capital gains rate (for those filing MFJ it is up to $80,000 of income). However, ordinary income gets taxed first so if total taxable income exceeds the 0 percent rate threshold then you will lose out on the reduced or 0 percent rate.
- The new qualified business deduction (20 percent deduction) can increase if taxable income increases. However, you wouldn’t want it to increase too much because it may throw you into the phase out rules.
- The Net Investment Income Tax (NIIT) is a tax in addition to income tax that is triggered at higher income levels. A Roth conversion could raise income to the NIIT levels, therefore adding an additional tax to the conversion year.
All these factors must be considered. Therefore, an accurate tax projection is critical to determine if a conversion should be made, and if so, how much should be made. Keep in mind, it is possible to stagger the conversions over a set number of years to lower your tax.
Recent tax law changes and client perception and desires also impact the Roth Conversion analysis.
- The TCJA eliminated recharacterizations of Roth conversions, so once made, they are permanent.
- The SECURE Act eliminated the stretch IRA beginning in 2020. Prior to the SECURE Act, if you inherited an IRA you could generally stretch your taxable distributions over your life expectancy. Now, those inherited IRAs must generally be withdrawn within 10 years following the death of the account holder. Tax-free Roth IRA distributions wouldn’t cause adverse tax implications on the accelerated distributions.
- The CARES Act eliminated RMDs for 2020. The elimination of the RMD allows a taxpayer to roll over what would have been their 2020 RMD too, allowing it to be converted as well. Perhaps 2020 income is lower due to the waived RMD, causing the conversion to be taxed at lower rates.
- The qualified charitable distribution is another consideration in determining whether to convert. If you are charitably inclined and the minimum required distribution will be used to make charitable contributions as a qualified charitable distribution, there is no taxation of the distributions. In this case, there is no advantage of doing a Roth conversion on funds to be used for that purpose.
- Do not convert if the taxpayer thinks their tax rates will go down in future years.
Once you have determined that a Roth conversion is right for you, remember It is also advisable to pay the tax with funds outside of the IRA fund, especially if a 10 percent early withdrawal penalty would be involved. This will also allow more monies to grow tax-free.
As illustrated above, there are many tax and nontax considerations when deciding on a Roth conversion. Taking the time to analyze your taxable income and the effects a conversion will have on that income are crucial in deciding whether it is appropriate and how much to convert. Consult our Bonadio experts to learn more.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute an accountant-client relationship.