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Though 2020 has taken its toll on investors, opportunities still exist. Consider a Roth IRA conversion — but review these four important factors beforehand.

Personal finance

Is This the Year to Convert Your Traditional IRA to a Roth?

  • Curtis Williams
  • 8/18/2020

Key insights

  • 2020 may be the year to consider a Roth IRA conversion.
  • Only convert if you expect your income tax rate to be higher in the year you plan to withdraw funds than it is today.
  • Pay the tax liability from conversion with external funds and assets in the year of conversion to increase long-term value and keep funds from a Roth IRA conversion in the account for at least five years.
  • Everyone’s circumstance is different so consult an advisor before converting to a Roth IRA.

Have you considered a Roth IRA conversion?

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While COVID-19 has made 2020 a difficult year for investors, opportunities do exist if you look in the right place. For long-term investors, retirement plan accounts — more specifically, Roth IRAs — may present one of these opportunities. If you’ve considered a conversion from a traditional IRA to a Roth IRA, now may be the year to take action. Understand the key differences between the two IRA options, as well four common factors to consider before you convert.

Roth IRA versus traditional IRA

Roth IRA contributions are made with after-tax dollars and the growth and income that accumulate in the account is generally tax-free upon withdrawal. Traditional IRA contributions, which are dependent upon the taxpayer’s income level, can be tax-deductible, but all growth and income is tax-deferred until funds are withdrawn from the account.

Since their creation in 1997, Roth IRAs have grown in popularity as an incredibly tax-efficient retirement planning tool. However, if your compensation is above IRS income limits, the only way to access a Roth IRA outside of a company-sponsored retirement plan is to convert from a traditional IRA to a Roth IRA.

Ask yourself the following four questions and review COVID-19’s potential impact on each to help decide whether a conversion makes sense for you.

1. Is your income tax rate lower now than when you plan to withdraw the funds?

From a tax perspective, here’s the simplest thing to remember: only convert if you expect your income tax rate to be higher in the year you plan to withdraw funds than it is today.

COVID impact: generally positive

Legislative changes or a decreased level of income are the two primary ways your personal income tax rate could be lower in the current year than it is in a given future year. The Tax Cut and Jobs Act of 2017 and the CARES Act enacted in 2020 contained numerous favorable provisions that resulted in a lower marginal tax rate for many taxpayers. Depending on future legislative action, taxpayers may experience some of the lowest marginal tax rates in 2020.

Additionally, many taxpayers have experienced a significant decrease in income this year due to salary reductions, business operating capacity reductions, and job loss and/or business closures. Consider a Roth IRA conversion if you are in a lower tax bracket this year and expect to return to a higher tax bracket in the future.

Lastly, the CARES Act allows taxpayers subject to the Required Minimum Distribution (RMD) to forgo a distribution in 2020. This provision could allow retired taxpayers to experience a lower level of taxable income in 2020.

These impacts present an uncommon opportunity to consider and potentially benefit from a Roth IRA conversion in 2020.

2. Can you pay the taxes due upon conversion?

The amount of funds, or lack thereof, to pay the tax liability of a Roth IRA conversion is typically the most common reason clients decide against it. Using external funds to pay the tax liability in the year of a conversion increases long-term value. Calculators (such as this one) can illustrate this clearly.

COVID impact: neutral

Savings that would be used to pay the conversion tax liability may have been depleted as a result of the economic effects of COVID-19, but each individual’s financial circumstances vary and aren’t directly correlated to this aspect of a conversion. Generally speaking, if you have to use funds inside the IRA to pay the taxes upon conversion, a conversion is less beneficial.

3. Do you need the funds in the next five years — or do you need them at all?

The ability for funds to grow tax-free is the most significant benefit of a Roth IRA, and the likelihood of a positive return — which will also be withdrawn tax-free — increases the longer funds remain invested in a Roth IRA.

Roth IRAs have the added benefit of not requiring minimum distributions, which now begin at the age of 72 for traditional IRAs. If you do not expect to need the funds at age 72 and beyond, a Roth IRA can be a great way to allow for longer-term, tax-free growth and serve as a legacy planning tool to pass wealth to the next generation.

There are many nuances to be aware of before you convert to a Roth IRA. For example, funds received from a Roth IRA conversion should generally remain in the Roth IRA account for at least five years so that taxes and penalties are not assessed when distributing the Roth IRA funds out of the account. There are several factors to mitigate some of these negative consequences, such as the age of the IRA owner and whether the Roth IRA account has been funded in the past. Consult with your advisor to review these factors before an IRA conversion.

COVID impact: neutral to positive

While not directly correlated to COVID-19, the SECURE Act (enacted December 20, 2019) may be a factor in the decision to convert since it eliminated the ability for those who inherit IRAs to stretch RMDs over the span of their own lifetime. As a result of this legislation, non-spouse beneficiaries must generally withdraw the full balance of an IRA within 10 years and pay the tax associated with these distributions. If you plan to utilize a Roth IRA as a tool to accomplish legacy goals and transfer assets to future generations, consider a conversion, pay the tax, and leave your beneficiaries a tax-free asset.

4. Is the market value of your IRA significantly lower than usual?

Take advantage of the tax-free growth benefit with positive performance from the time of conversion to withdrawal. The higher the investment returns experienced in the portfolio after a Roth IRA conversion, the greater the tax-free benefit will be for the Roth IRA owner or its beneficiary.

Spikes in market volatility with significant market declines (such as we have seen in 2020) should be a catalyst for a conversion conversation with your advisor. A decline in market value is a decline in the cost to convert. Additionally, the potential for tax-free growth in a subsequent market rebound would then be relatively higher.

COVID impact: neutral to positive

In hindsight, a perfectly timed Roth IRA conversion in March, April, or May of this year — when stock market values had plummeted more than 30% — would have been a great strategy for many investors. However, not all investments have fully recovered to their previous valuations and markets could still experience another decline before year-end, so this strategy is still in play. A well-timed conversion in the third or fourth quarter of this year could create the opportunity for significant tax-free growth in a Roth IRA.

Additional consideration for a Roth conversion

The CARES Act also brought the elimination of the gross income (AGI) charitable deduction cap for cash contributions from individual donors. This means you can now elect to deduct up to 100% of your AGI (increased from 60%) for cash contributions made to public charities in 2020. If you plan to make sizeable charitable donations with cash, there is an opportunity to pair that with a Roth conversion and effectively convert a traditional IRA to a Roth with no corresponding tax liability.

As with any investment, there are risks associated with Roth conversions. Each individual’s circumstances are different so we encourage you to consult an advisor before making a final decision.

How we can help

While things change by the day, it will always be important to plan for your future. Seek input from your advisors to determine if a conversion is a good strategy. At CLA, we understand this has been an unusual year, and our team stands ready to answer your questions and provide assistance to meet your specific needs.

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  • Curtis Williams
  • Senior Wealth Advisor
  • CliftonLarsonAllen Wealth Advisors, LLC