If you’ve ever considered doing a Roth conversion, 2020 could be the year to do it. A mix of market conditions, tax rates, legislation, and other considerations mean this could be the best time for many investors, especially high earners, to choose a Roth IRA conversion.
A Roth IRA can be a great option for many investors. While contributions are made on an after-tax basis, it allows for tax-free growth potential and tax-free withdrawals for both you and your heirs in most cases. With a Roth IRA, you are not required to take minimum distributions, so it can be a valuable way to grow your savings for retirement and beyond. This investment vehicle provides more tax benefits in retirement and flexibility than a traditional IRA.
However, high-income earners are prevented from contributing to a Roth IRA due to the IRS's income limits. The good news is, you may still have the option to hold a Roth IRA by taking your existing funds from a traditional IRA or other retirement savings account and doing what’s called a Roth IRA conversion.
The economic impact of COVID-19 and uncertainty that followed has wreaked havoc on the markets, leading to instability and driving us into what has officially been declared a recession. Facing unprecedented and unusual circumstances surrounding the pandemic-driven economic downturn, the federal government has taken measures to protect taxpayers that could work in your favor, particularly when it comes to Roth IRA conversions.
Low Market Prices
While attempting to time the market can always backfire, history suggests that markets recover after a crash. If the market recovers after you've made a Roth IRA conversion, you will benefit from getting in at lower rates. Making a conversion at a lower value means paying taxes on that lower value. When the market rebounds to its higher value, you'll be getting a bargain and tax-free Roth IRA.
Low Tax Rates
While we are experiencing low tax rates now, taxpayers will need to pay for the $2 trillion in federal bailout at some point. Chances are, high-income earners, people with sizable retirement accounts, and their heirs will come out of pocket for this with future tax hikes. But if you make a Roth IRA conversion now and the income tax rates rise in the future, this means you’re making the conversion at bargain rates. If you believe taxes are going up in general or that tax rates will specifically increase for you, then now would be a favorable time for a Roth IRA conversion.
Required Minimum Distribution (RMD) Waiver
Thanks to the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) required minimum distributions from traditional IRAs and retirement plans have been suspended. This means you can forego your distribution in 2020 if you don’t need the cash, even if you were required to take RMDs in the past. And if you don’t take a distribution from a traditional IRA, this can make doing a Roth IRA conversion even more advantageous by reducing your taxable income and placing you in a more favorable tax bracket. So if you are going to do a Roth IRA conversion this year, it may provide the opportunity to convert a larger amount.
The SECURE Act
Before the global pandemic affected the market, we were already facing a change that could negatively impact your financial legacy — the SECURE Act, which went into effect on January 1, 2020. This change dramatically accelerated the income tax on inherited IRAs in the decade following the original owner’s death. A Roth IRA conversion could be an effective strategic tool and one of the best defenses to protect your family’s financial legacy for certain taxpayers if timed correctly.
While many investors could benefit from taking advantage of a Roth IRA conversion in 2020, it would not work to everyone’s advantage. We may be experiencing a down market for some time, so you will want to avoid depleting your liquidity or putting yourself in a financial bind to pay taxes on a Roth IRA conversion. If you need to have the cash on hand in the next five years, a conversion may not be a risk worth taking.
How to Convert to a Roth IRA
Before converting to a Roth IRA, you would first need to have opened and funded a traditional IRA. Because only post-tax dollars go into a Roth IRA, you will need to pay taxes on your traditional IRA contributions and investment gains. Specifically, those contributions and gains will be added to your taxable income when you file your 2020 tax return. If the market does not bounce back in the meantime, you will have less to pay.
If you don’t already have a Roth IRA, open a new account, and choose from one of three options to convert your traditional IRA.
You can do an indirect rollover. This is where you would get a distribution for the traditional IRA and use those funds to contribute to your Roth IRA within the following 60 days.
Another option would be to do a direct rollover, also known as a trustee-to-trustee rollover. This is where you would request that the financial institution that holds your traditional IRA to transfer funds directly to the trustee of the financial institution where your Roth IRA is held.
If both accounts are at the same financial institution, you can request the same trustee transfer from your traditional to your Roth IRA.
How Much to Convert in a Roth IRA Conversion
If converting to a Roth IRA makes sense for you in 2020, it’s important to look carefully at the numbers to determine how much of your funds to convert. In general, you will want to compare the estimated future value of keeping the money invested in a traditional IRA versus how values will be affected should you convert it to a Roth. You will also want to look at the taxes you would owe with the conversion.
When deciding on an amount, it’s important to factor in your cash flow requirements along with tax considerations. If you convert a traditional IRA with a substantially large balance, this could push you into a higher tax bracket and tie up funds in tax liability. As a general rule of thumb, only take on as much extra taxable income from your conversion that would not cause your tax rate to spike. While 2020 may be the most favorable time for a conversion in our lifetime, keep in mind that you can split your conversion strategy over multiple years.
The Bottom Line
Even if the market takes a long time to recover, a Roth IRA conversion can be beneficial over the long term. This strategy is an effective way to leverage your portfolio to lock in gains tax-free. Keep in mind, your gains in a Roth IRA are tax-free for the remainder of your life, that of your spouse, and typically for your heirs.
Robert "Fenn" Giles, Jr., MBA, CIMA® is a founding partner of Wealth Advisors of Tampa Bay (WATB) and acts as the firm’s President and Chief Investment Officer. WATB is an independent Registered Investment Advisor (RIA) located in Tampa, Florida. Learn more about them at wealthadvtb.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.