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Is Now a Good Time to Consider a Roth Conversion?

What are the current conditions that may allow Roth conversions to be subject to lower tax rates now than when distributions are made to beneficiaries in the future?

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What are the current conditions that may allow Roth conversions to be subject to lower tax rates now than when distributions are made to beneficiaries in the future?

Amidst the current turbulent economic conditions lies a potential opportunity for taxpayers who have retirement accounts, such as traditional IRAs, to convert all or a portion of their retirement account to a Roth IRA.  A Roth IRA is like a traditional IRA with the main exception that qualified distributions from a Roth IRA are tax-free while distributions from traditional IRAs are taxable to the extent they exceed basis in the IRA.  Another difference is that the required minimum distribution (RMD) rules do not apply to Roth account owners.  Therefore, a Roth IRA owner is not required to take distributions from their Roth IRA during their lifetime.

While this may sound like Roth IRAs are clearly superior to traditional IRAs, there is a cost to converting a traditional IRA to a Roth IRA.  The cost is an upfront tax on the income portion of the amount converted to the Roth IRA.  For example, if you have a traditional IRA with a value of $20,000 and no basis in the account, converting the IRA to a Roth IRA will result in $20,000 of taxable income.  Because there is a tradeoff between paying tax now and future tax-free distributions, conversions to Roth IRAs make most financial sense when the tax rates in effect at the time of conversion are lower than the tax rates in effect when distributions will be taken from the Roth IRA.

An example may be helpful.  Let’s say you decide to convert your entire $20,000 traditional IRA to a Roth IRA in 2020 and you are in a 22% tax bracket.  The tax cost of conversion will be $4,400.  If the $20,000 is distributed tax-free to your beneficiary at a time when they are in a 35% tax bracket, their tax savings would be $7,000.

So, what are the current conditions that may allow Roth conversions to be subject to lower tax rates now than when distributions are made to beneficiaries in the future?

  • Current tax rates are historically low. Given the cost of recent government relief and stimulus packages and an election in November, it is quite possible that future tax rates will be higher.
  • The investment markets have suffered upheavals that might lead to lower IRA account values. Since the taxable income of converting to a Roth IRA is based on values at the time of conversion, the tax cost is lower when asset values are lower.  If the value of these assets recovers after conversion, the future appreciation will be tax-free.
  • Individuals’ income may be lower in 2020 due to reduced earnings or losses from business interests. This may reduce an individual’s tax bracket further reducing the tax cost of conversion.  In extreme cases, taxpayers may have negative taxable income and can completely eliminate the tax cost of conversion.

One common strategy is to convert just enough of an IRA to a Roth to stay below a certain tax bracket, such as the 22% or 24% bracket.  This strategy can be utilized over several years.

The decision to do a Roth conversion involves considerations other than those discussed here so you should be sure to discuss with your tax advisor.  However, the current circumstances may make a Roth conversion particularly appealing.

 

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

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