By Derek Holman, CFP
No question, the coronavirus has created angst and uncertainty, but how can you adapt and make the best possible decisions for your financial future? Amid this uncertain economic environment, you should become familiar with new regulations.
One example is the recently enacted SECURE Act, which temporarily changed the terms of required minimum distributions (RMDs) for all retirement plans, including IRAs, 401(k)s, 403(b)s and even inherited IRAs. Previously, RMDs went into effect after the participant or owner reached the age of 70 ½. Now, if you reach 70 ½ in 2020 or later, you must take your first RMD by April 1 of the year after you turn age 72.
Additionally, as the government has tried to offset the myriad of economic consequences of the coronavirus, one of the provisions of the new CARES Act was to suspend the requirement to take a minimum distribution at all in 2020. In lieu of that distribution, it could be advisable to convert money from your traditional IRA to a Roth IRA.
Recognizing the Role a Roth IRA can Play
The Roth IRA is a great retirement and estate planning vehicle because you don’t have to pay income tax on the growth. With a regular IRA, although you receive a deduction upfront, any money withdrawn in the future is taxed as regular income, not based on the lower long-term capital gains rate. With a Roth IRA, you don’t get an initial deduction but the account grows tax-free as long as money remains in it, and no RMDs go into effect until after the death of the owner. So the longer you stay invested in a Roth IRA, the more tax-free growth you should be able to obtain.
Roth IRAs can be funded in two ways. One option is a direct contribution, but the IRS has capped the amount that can be directly contributed to a Roth each year. If a participant has earned income, the maximum Roth IRA contribution for 2020 is $6,000 (people who are at least 50 years old can allocate $7,000). However, if you earn over $139,000 of modified adjusted gross income as a single filer or $206,000 as a joint filer, you can’t contribute directly to a Roth IRA at all.
Fortunately, there’s another way to put money into a Roth if you have too much earned income or no earned income. That’s by converting funds from a traditional IRA. The government loves this conversion and applies no restrictions on it because taxes must be paid this year rather than sometime in the future. Technically, you could convert $1 million from an IRA to a Roth if you wanted to, which would result in $1 million of reportable income on your tax return and the applicable tax paid to the government.
RMDs typically start at a little under 4% of the balance and increase each year. Traditional IRA investors who have been taking only the RMD in previous years likely don’t need that money to live off. Since an RMD isn’t mandated this year, you could instead convert those funds from your IRA to a Roth. If the RMD would have been $5,000, you’ll still have that amount of reportable income on your return, similar to last year. But now the money would be in your Roth and able to grow tax-free for years to come.
Understanding your Tax Allocations
Another important consideration is to pay the tax on the traditional IRA disbursement out of sources other than the money you’re contributing to the Roth. So if you convert $5,000 and owe $1,000 in taxes on that disbursement, pay it from separate funds to ensure the full $5,000 goes to the Roth rather than only $4,000. Over the long term, that will be more beneficial than simply converting the net amount. If you are under age 59 ½, penalties would not apply to the amount that is converted but may apply if you withhold a portion to pay the tax.
Additionally, since the money in a Roth IRA grows tax-free, you’ll want to be very selective about spending it. From a planning perspective, it’s basically the last bucket you should tap into to facilitate your living needs in retirement. You can also transfer the Roth IRA to heirs upon your (or your spouse’s) death. Although they would need to take an RMD each year, your heirs could choose to let the majority of the balance continue growing for another 10 years. Over the course of your and your spouse’s lifetime plus an additional 10 years, a tremendous amount of tax-free growth is possible.
Investment Growth Opportunity in a Volatile Market
The unpredictable market performance this year has caused headaches for many investors, but such volatility creates opportunities as well. From the standpoint of a Roth conversion, steep market declines enhance the potential benefit.
Because money grows tax-free in a Roth IRA, you should take advantage of that growth as much as possible. Let’s say you have $100,000 in a traditional IRA that’s entirely invested in stocks. If those stocks go down 30%, you’re left with $70,000. By converting that money to a Roth, you only pay tax on $70,000. Then assuming the market rebounds and you reach $100,000 again, you will have earned $30,000 in tax-free growth, versus that money growing in your IRA and eventually being taxed as ordinary income.
In a typical year where the market doesn’t experience a steep decline, the same opportunity wouldn’t exist to generate significant tax-free earnings. So in theory, if you invest when the market is low, you enjoy the dual benefit of lower tax on the amount you’re converting and higher tax-free growth in the Roth. While a Roth conversion could make great sense anyway this year due to the lack of an RMD, the volatility we’ve experienced only adds greater possible incentive to the transaction.
About the author: Derek Holman
Derek Holman, CFP®, AIF®, is co-founder and managing director of EP Wealth Advisors, an independent registered investment adviser that specializes in client-centric financial planning and investment management services. Derek co-founded the firm in 1999 to change how consumers received financial services. He has over two decades of experience in wealth management. His areas of expertise include comprehensive investment management, retirement planning, and estate and tax planning.