To say that 2020 has been a trying year for investors so far is an understatement. Even with the recent gains off of the lows, the major stock market averages are well off their record highs.
Lower market valuations are one of several factors that makes this year a good time to consider whether a Roth conversion is a good strategy.
Since tax reform was enacted at the end of 2017, income tax rates have been reduced across the board. This means that the funds converted will be taxed at a lower rate, resulting in a lower tax bill, and potentially allowing for a larger amount to be converted.
The decline in the stock market means that account values for traditional IRA accounts will be lower in most cases. As a result, a higher percentage of the account can be converted to Roth IRA under these lower tax rates and then be allowed to grow tax-free when market conditions improve. Assuming an eventual market rebound, retirement savers will be doing the conversion at a bargain rate, so to speak.
As part of the CARES Act enacted in response to the coronavirus pandemic, required minimum distributions on retirement accounts have been waived for 2020. The ability to forego RMDs in 2020 means less taxable income. Any tax incurred on a Roth conversion would not be on top of taxes on RMDs in 2020. This is an added benefit for those who would otherwise be required to take an RMD for 2020 and pay tax on this money.
The money not taken as an RMD from a traditional IRA account would be eligible for conversion to a Roth. For those whose RMDs are large, this could be significant. For example, an individual whose RMD would otherwise be $50,000 or more can now take this amount and convert it to a Roth IRA. This amount remains in a tax-sheltered account and grows tax-free.
Additionally, this amount will not be subject to RMDs in future years.
The SECURE Act eliminated the ability to use the stretch IRA tactic to pass accounts to most non-spousal beneficiaries as in the past. Now these beneficiaries will need to withdraw the funds from the inherited IRA account within 10 years, versus being able to stretch out account withdrawals via the use of RMDs over time. This could result in a larger percentage of the account being subject to taxes, diminishing the benefit to these beneficiaries.
Converting some or all of a traditional IRA account to a Roth IRA can be a tool for investors to consider in passing this money to their non-spousal beneficiaries in a more tax-efficient way. While they will need to pay taxes on the account in the year the conversion is done, their heirs will have the opportunity to withdraw the funds on a tax-free basis.
Investors will need the help of a financial adviser to determine whether paying the taxes now to help their beneficiaries gain the tax benefits of inheriting a Roth account in the future is a good overall financial move.
Investors should review their tax rates and compare them with the current and anticipated tax situations of the intended non-spousal beneficiaries.
The factors mentioned above would generally apply to those who earn too much to contribute to a Roth IRA and for whom a backdoor Roth IRA is appropriate as well. Any taxes that might be due on the converted amount are taxed at a lower rate, and the amount converted has a chance to grow inside the Roth IRA during any market rebound.
For those who are using the mega backdoor Roth technique with their workplace retirement plan, 2020 could be a good year to do the combination in-service withdrawal/Roth conversion if your client is eligible to do so.
For those whose 401(k), 403(b) or other workplace retirement account offers a Roth option, they should consider converting some or all of their traditional 401(k) balance to the Roth option. They can then roll this portion of the account balance to a Roth IRA when they leave their employer.