By Jim Blankenship, CFP
The year 2020, extraordinary in many ways, appears to be an optimal year for Roth conversions. There is a “perfect storm” of factors that have come together in 2020, making a Roth conversion an excellent move for many savers. These factors include: The recent passage of the SECURE Act, with its changes to beneficiary distributions; the waiver of required minimum distributions (RMDs) for 2020 with the CARES Act; plus the fact that we’re living with the lowest tax rates in recent history. Add in the possibility of reduced valuations in IRA and 401(k) accounts due to market losses, and the scene is set for some significant activity in the Roth conversion arena.
Lower Market Levels
Earlier in the year, we saw a significant drop in the overall stock markets. The S&P 500 dropped by more than 30% in roughly a month. And although we’ve seen much of that drop regained since the market low, it’s possible that we’ll see more of this downside volatility in the remainder of the year as COVID-19’s impact plays out.
With a lower market valuation, the cost of a Roth conversion is reduced. If you timed it just right and converted a stock holding from your IRA to Roth in late March 2020, you would owe tax on a holding that is now worth 40+% more than when you converted. So for example, if you owned $10,000 worth of S&P 500 (value as of February 19) and converted that holding to Roth on March 23 at a value of $6,600 – your tax cost (at an assumed 22% rate) would be $1,452. As of this writing, the original $10,000 holding is now worth approximately $9,400 – making your real cost of the conversion something like 15%.
So if the market takes another dive throughout the remainder of the year, you might want to pull the trigger on a Roth conversion to take advantage of this market valuation factor.
SECURE Act Changed the Rules
When the SECURE Act became law late last year, the rules for non-spouse beneficiaries of inherited retirement plans changed dramatically. Where previously a child beneficiary could stretch out distributions from an inherited IRA over his or her lifetime, now this beneficiary (with limited exceptions) must withdraw the entire account within 10 years after the death of the original owner.
This has caused quite a bit of discussion in the retirement planning community. One of the significant points is that the original owner may be in a better position to shoulder the tax burden (at least a part of it) in today’s low tax rate environment.
Mom and Dad have moderate IRA holdings amounting to $250,000, and they plan to leave as much of the IRAs to their children as possible. Mom and Dad are in one of the lower tax brackets, with their general income requirements met by other sources which will not outlast their lifetimes – Social Security and pensions.
In contrast, their children are in the height of their earnings years, paying tax in the upper echelons of the brackets.
If Mom and Dad undertake systematic Roth conversions, keeping the applicable tax rate within the 22% bracket (for example), at their passing, the maximum amount of the original IRAs would be preserved, and the heirs would receive the money tax-free at that point. Granted, they still have to take the money out within 10 years, but under today’s rules, there is no tax on the withdrawal of inherited Roth IRA money.
If they don’t convert to Roth, whatever is remaining of the IRAs at Mom and Dad’s deaths will have to be distributed to the children within 10 years of their death(s). This could come at the highest possible tax rates, depending on the timing of the distributions.
Lowest Tax Rates in Recent History
Since 2018 we’ve enjoyed the lowest tax rates in a lifetime. The Tax Cuts and Jobs Act of 2017 ushered in these low rates, which are scheduled to continue until 2025 under present law.
However, with recent Congressional spending related to the pandemic situation, as well as with the proposals for healthcare and other programs we’ve seen bandied about, it’s highly unlikely that these low rates will see 2025. The greater likelihood is that we’ll see significant increases to these current rates as soon as 2021, but more likely in 2022.
With this in mind, the IRA (or 401(k) plan) holder is currently in the catbird’s seat. If you’ll recall, one of the decision factors about whether to defer money into an IRA is your expectations about tax rates. The byword is that if you can defer income in a higher taxed year to a year when taxes are lower, you should do so.
Chances are that you reduced your income by making tax-deductible contributions to IRA or 401(k) accounts in those accumulation years at much higher tax rates than we see today. So far so good, you’re playing the game correctly if you take money out of the deferred accounts today at the much lower tax rates.
On the other hand, a tenet of Roth conversion planning also takes into account your expectations of future tax rates. For a Roth conversion to make sense, we want some degree of expectation that the tax rate we would pay on the conversion is lower than a future tax rate we’d pay on a distribution from the IRA or 401(k) account. Again, I think doing a Roth conversion for many people today fits these circumstances perfectly.
So the tax brackets are working in your favor – you deferred income from the high tax years and now we’re seeing low tax brackets. These low tax brackets aren’t going to last for long, so the time is ripe to enact a Roth conversion.
CARES Act Eliminates RMDs
The latest legislation coming to the party is the CARES Act. Part of the CARES Act waived Required Minimum Distributions (RMDs) for IRA and 401(k) owners for 2020 (as well as beneficiaries of these accounts). For the IRA owner who typically takes the RMD money and places it in a savings account or some other non-tax-deferred vehicle, the waiver of RMDs for 2020 presents the opportunity for Roth Conversion.
If you didn’t need the money for life expenses anyway, you might look at 2020’s RMD waiver as a gift – where you can enjoy a year with a slightly lower income tax bill, since you’re not required to take the distribution. If there’s no distribution, your income will be lower, as will your tax bill.
However, if you’re already accustomed to the tax bill from prior years’ RMDs, why not take this opportunity to withdraw what would have been your RMD and convert that money over to Roth? Normally, if an RMD is required for a particular year you can’t convert that withdrawal to Roth IRA – only the amounts above your RMD can be converted. But for 2020, you can convert even your first dollar of withdrawal from your IRA.
Perhaps you could split the difference. For example, if your IRA is worth $300,000 and you are 73 years old in 2020, your RMD would have been $12,146. Instead of just bypassing the RMD altogether and enjoying an income that is $12,146 less for the year, why not convert half of it to a Roth IRA, and skip the other half. This way you’ll still get to enjoy a slightly lower tax bill, but you’ll also have $6,073 in a Roth IRA, growing tax-deferred, and tax free for withdrawals in the future. Plus, when things return to normal in 2021 (assuming they do), your IRA balance against which the RMD is calculated will be $6,073 less.
About the Author: Jim Blankenship, CFP®
Jim Blankenship is a certified financial planner with Blankenship Financial Planning, a blogger, and author of A Social Security Owner's Manual and Social Security for the Suddenly Single: Social Security Retirement and Survivor Benefits for Divorcees.