Pay Now, Pay Never

It’s no secret that my interest in Roth conversions has grown over the past year. For those avid readers of our bi-weekly postings, I’ve hinted at utilizing Roth conversion in my last three articles. While there has always been an argument for some to convert IRA dollars to Roth, Congress vastly improved the case for converting with the passing of the SECURE Act. Whether you’re fresh out of college starting your first job, well into your career, or kicking back and enjoying your retirement, it’s crucial to know how these changes to Roth conversions can impact your financial well-being, and the well-being of your future generations.

To quickly summarize, a Roth conversion takes place when an individual transfers funds directly from a Traditional or Rollover IRA into a Roth IRA. In almost all cases, this transfer will trigger a taxable event where the account holder will report the converted amount as ordinary income. Taxes can be withheld during the transfer, but it is typically recommended that the tax be paid from cash or taxable assets. Additionally, it may be advisable to make estimated quarterly tax payments in conversion years to avoid a potential IRS penalty. Once funds have been deposited into a Roth IRA, there will be no future tax upon withdrawal along with several benefits outlined below.

Changes to Inherited Retirement Accounts

Possibly the largest change brought on by the SECURE Act was the removal of the stretch IRA. Beneficiaries of retirement accounts are no longer permitted to distribute funds through their lifetime, but instead must do so over a 10 year period. This change applies to both Traditional and Roth IRAs. Beneficiaries of Traditional IRAs will likely realize a larger tax as they are required to accelerate withdrawals. However, Roth IRAs will maintain their tax free status upon withdrawal. This would allow beneficiaries to grow an inherited Roth IRA for the entire 10 year period, and withdraw all assets on the last day tax free. Individuals may want to consider relieving their heirs of potential tax burdens by paying a portion of that tax themselves.

Historically Low Tax Rates

Taxes are low. Very low. While there is a debate as to whether rates will increase, decrease, or stay at their current levels, there is no arguing their current levels offer opportunity. In converting to a Roth IRA, individuals can lock in today’s tax rate and remove the uncertainty in future tax direction. Not only that, but it also helps improve tax diversification which we recently wrote about here. No one likes paying taxes unless it's absolutely necessary, but one way or another the IRS will get their share. There may be a benefit to making that payment when you have more control over the amount.

Reduce Future Required Distributions

Traditional IRAs, 401(k)s, 457(b)s, and numerous other retirement accounts are subject to required minimum distributions (RMDs) in the year the account owner turns 72. The size of the RMD is based off the value of the account at the end of the prior year, and the age of the account holder. Early on, the required withdrawal will float around 4% of the account, but as years pass, that percentage will quickly increase. Roth IRAs are exempt from RMDs, meaning they potentially have decades of additional untouched growth. Not only that, but as funds are transferred out of Traditional IRAs, the size of the account is reduced. This in turn reduces future RMDs as account size is one of the calculation factors.

2020 RDM Waiver

In recognition of the many challenges Americans faced this year, Congress has suspended the RMD for 2020. This could potentially entice retirees to convert in a year where they are likely facing reduced taxes. For example, say Bob is 76 with $2 million in IRA assets and $1 million in a Trust. His only sources of income are social security and a small pension, so he typically relies on his portfolio for additional income. Bob's RMD is taken at the end of each year, but this year he may be better off suspending his 2020 RMD, performing a Roth conversion, and paying the tax from his Trust. Just because there is no RMD in 2020 does not mean every IRA holder should stop IRA withdrawals or convert to a Roth IRA.

There are several key components behind a Roth conversion and they all must be carefully reviewed prior to making a transfer. Taxes, healthcare premiums, even portfolio allocation, will be impacted. As of 2018, Roth conversions can no longer be re-characterized, meaning that once a conversion is made, there is no reversing it. Even given the challenges, Roth conversion can prove to be an excellent planning tool not only for you, but also for those you love.

Joe Crowley, CFP® is an Investment Advisor at Exchange Capital Management.  The opinions expressed in this article are his own.