As year-end approaches, taxpayers and tax professionals alike are doing their best to navigate the intricacies and unknowns associated with tax planning in an election year almost entirely enveloped by the COVID-19 crisis. Many taxpayers will have lower income and investment contributions well below what’s generally expected in less eventful years. In years with lower income, a Roth IRA conversion may be beneficial.
Generally, we’re looking at converting a traditional IRA to a Roth IRA; however, other conversion opportunities exist, such as converting from a Rollover IRA, SEP IRA, or an old 401(k). As we get to year-end, I am completing tax projections for clients to determine the marginal tax rate benefit of the conversion. For many taxpayers, a closer look at a conversion may prove it to be a smart tax planning move for 2020.
What are the general benefits of choosing a Roth IRA?
In general, pandemic years aside, Roth IRAs have a number of potential benefits worth considering as part of your overall retirement plan. They allow the account holder to grow tax-free investments and to make tax-free transfer to heirs. Roth IRAs do not have required minimum distributions (RMDs). Once you have reached the age of 59 ½ and your IRAs 5-year aging period has been met, withdrawals, anytime and for any reason, are tax-free and penalty-free. Additionally, there are no eligibility requirements to convert.
Why may now be a good time, specifically?
Under current law, Roth IRA contributions may not exceed $6,000 ($7,000 if you’re 50 years of age or older), or your taxable compensation for the year, if it is less. If contributions are made over the allowable limit, a 6% excise tax per year will be imposed on the excess amount for each year it remains in the IRA.
For 2020, tax filers with MAGI of $124,000 or more ($196,000 or more if married, filing jointly) are ineligible to contribute, and tax filers with MAGI between $124,000 and $139,000 (between $196,000 and $206,000 if married, filing jointly) may only contribute a reduced amount. For 2021, tax filers with MAGI of $125,000 or more ($198,000 or more if married, filing jointly) are ineligible to contribute, and tax filers with MAGI between $125,000 and $140,000 (between $198,000 and $208,000 if married, filing jointly) may only contribute a reduced amount. With lower income, and thus lower MAGI, expected going into 2021, some taxpayers who were previously ineligible or limited in their contributions, will have the opportunity to contribute to a tax-free pool of cash.
If you own a pass-thru entity and you are entitled to claim a loss, a Roth IRA conversion can be advantageous because you will report income that possibly will not be subject to any tax. Self-employed, Schedule C filers with 2020 exemptions and deductions that exceed their 2020 AGI may have negative taxable income as a result. This means income may be added, up to the negative amount, without incurring any tax.
Generally, you have to pay any RMDs before converting to a Roth IRA; however, the CARES Act waived the RMD for 2020, so a conversion now would not require payment of the RMD beforehand. Current tax rates may be lower than what’s in store for future rates as well, especially considering the post-election uncertainty as we transition to a new administration. Lower income for the year may also put you at a lower tax rate, which makes a conversion less costly.
What are the cost considerations related to a conversion?
A Roth IRA conversion can have major effects on your taxes, so understanding the possible outcomes and performing relevant projections are key considerations. I assist my clients with tax projections to determine the marginal tax rate benefit of the conversion. I work with many of my clients’ investment advisors to determine the cost-benefit analysis.
It’s also important to remember that a Roth IRA must be in existence for 5 years following the first contribution before a withdrawal of earnings can be tax-free. Even if you reach the age of 59 ½ before that 5-year aging period ends, you still have to wait.
Converting a traditional IRA to a Roth IRA will generate taxable income, so care should be taken to ensure the conversion will not put you in a higher tax bracket. Conversion isn’t an all-or-nothing event, so you can tailor the amount you convert to match your ability to meet the resulting liability and stay within your desired tax bracket.
As a general rule, the tax liability from the conversion should not be paid with retirement funds if you can avoid it. Using retirement funds takes away your ability to maximize the growth of your tax-free investment, and, if you have not reached the age of 59 ½, your withdrawal is subject to the 10% federal penalty.
LGA’s Individual Tax Services Team can assist you in developing and implementing strategies to reduce your tax liability, maximize your tax benefits, and keep you on the right track to achieve your financial goals. Contact me today to discuss whether a Roth IRA conversion is a smart 2020 tax planning move for you.
Check out what else the LGA team is saying about tax planning during COVID-19.
by Marci Cohen
Marci Cohen is a Partner at LGA. She has over 30 years of experience in providing individual and entity tax planning and compliance services. Marci’s focus is on high-net-worth individuals and families with complex reporting and planning needs, as well as their associated trusts, estates, and entities. With her collaborative and diligent tax planning approach, Marci ensures that her clients are able to achieve their personal financial goals.