This year might be the best year for many of you to convert all or part of a traditional IRA to a Roth IRA. Roth IRAs are one of the most powerful retirement and tax planning vehicles. Earnings compound free of taxes. Distributions of the principal always are tax free, and distributions of income and gains are tax free after five years.
There are no required minimum distributions (RMDs) during the owner’s lifetime. Distributions to beneficiaries who inherit the Roth IRA also are tax free, but must be taken within 10 years.The difficulty many people have is that there’s a tax bill to converting a traditional IRA to a Roth IRA. The amount that is converted must be included in gross income as though it were distributed to the IRA owner. It is ordinary income, so it is taxed at the owner’s regular income tax rate. A large conversion can push the IRA owner into a higher tax bracket.
Despite the tax cost, a confluence of events could make this the best year to convert an IRA, especially for those who normally have to take RMDs. In 2020, RMDs are suspended for IRAs, 401(k)s and other defined contribution retirement plans. In normal years, when someone who is subject to RMDs wants to convert a traditional IRA to a Roth IRA, the RMD for the year first has to be taken from the traditional IRA. The RMD will be included in the person’s gross income for the year and can’t be rolled over to the Roth IRA. Only the amount remaining in the IRA after the RMD is taken can be converted to a Roth IRA, and the amount converted also will be included in gross income.
The rule that the RMD must occur first causes enough of a tax issue that many people do not want to convert an IRA when they are subject to RMDs.The restriction doesn’t apply for 2020, because RMDs are suspended. An IRA conversion is less expensive than it ever has been or is likely to be. You don’t have to include that RMD in gross income before making the conversion, so you can convert more of the IRA in 2020 at the same tax cost as in other years.
A second reason this is a good year to convert an IRA is the current tax rates are likely to be the lowest for quite some time. There’s legitimate concern that the deficit spending recently incurred to prop up the economy will result in higher income taxes in a few years. Also, a change in the administration and control of Congress is possible after this November’s elections, which could result in a push for higher income taxes. The bottom line is if you’re thinking of converting all or part of a traditional IRA at some point, it’s better to do the conversion before the tax rates increase.
A third reason 2020 is a good year to convert an IRA is market volatility. The tax cost of a conversion is deter-mined by the value of the IRA assets on the day they are transferred from the traditional IRA to the Roth IRA. In other words, the tax cost is determined on the day of the conversion. The value of the assets on any other day of the year doesn’t matter. It is less expensive to convert an IRA after its value has declined, especially when you believe the decline is temporary. There was a window to convert an IRA at a greatly reduced cost in late March when there was a liquidity crunch in the markets and all assets were declining. I pointed this out to readers in one of my weekly Bob’s Journal entries on the members’ section of the web site.
Since then, U.S. stocks have made a strong comeback. More importantly, market volatility is high and the rebound in stock prices is not yet sup-ported by a recovery in the economy. There’s also a lot of uncertainty about the course of the pandemic, geopolitics and other factors outside the markets.Taken together, these factors create the potential for another market drop sometime in 2020. A wise strategy is to monitor your IRA’s value for the rest of the year and be ready to trigger a conversion of all or part of the IRA if there’s another sharp decline in value.There’s a fourth reason this is a good year for some people to convert their IRAs.
Your income might be lower this year because of a period of unemployment, reduced business income, or very low interest rates. That could push you into a lower tax bracket than most years. When that’s the case, consider taking advantage of the lower tax bracket by converting part of the IRA. A number of my readers plan to leave most of their IRAs for their children or grandchildren to inherit.
When that’s the case, converting a traditional IRA to a Roth IRA can be a good estate planning strategy.When a loved one inherits a traditional IRA, he or she is taxed on distributions from the IRA just as you would have been. The beneficiary really inherits only the after-tax value of the IRA.
When you convert the IRA, however, you effectively are paying the future income taxes for the beneficiaries. The Roth IRA distributions will be tax free to them just as they would be to you. They’re inheriting the full value of the IRA, and taking distributions from the Roth IRA won’t push them into higher tax brackets.
This really is a gift to your beneficiaries, and it is free of estate and gift taxes. As far as the IRS is concerned, you’re simply paying your income taxes. But it really is a very generous gift to loved ones who inherit the IRA. The value of this gift is higher for those whose estates become subject to the federal estate tax. But it is a valuable gift even for those whose estates won’t be taxable.
When you convert an IRA, the best strategy often is not to convert it all at once. Instead, convert enough each year to keep from pushing you into the next higher tax bracket. All the factors to consider before converting an IRA are discussed in my book, “The New Rules of Retirement,” and in past articles that you can find in the Archive on the members’ section of the web site. The latest discussion was in the May and June 2018 issues.