When it comes to retirement planning, it is our job as financial advisors to help our clients make lemonade from the lemons of the tax code, legal system, or market conditions at any given time. One of the joys of our jobs here at URS Advisory is helping clients make financial decisions that will put them in a good position to reach their desired goals. That includes deciding when and how to allocate funds in a tax-efficient manner to maximize retirement income.
This year, many advisors may be recommending Roth IRA conversions to their clients since some provisions of the CARES Act may have made a 2020 conversion more appealing. Three unique conditions this year that may have investors considering a conversion are the waiver of Required Minimum Distributions (RMDs) in 2020, the possibility that the investor may have earned a lower income this year, or a diminished portfolio balance due to market volatility. However, it’s important to weigh the relative merits of both your current IRA and a Roth IRA to decide if a Roth conversion is right for you.
How Traditional IRAs and Roth IRAs Differ
Roth IRAs and traditional IRAs differ in a few ways, but the most significant difference is when taxes are assessed on your funds. With a traditional IRA, contributions are made tax-free, but are paid upon distribution. That is, they become a tax liability in retirement. One of the benefits of the Roth IRA is that after age 59 ½, withdrawals from a Roth can be made tax-free. Roths also don’t require accountholders to take RMDs at any time, making them especially attractive accounts to pass on to heirs. However, there are a few caveats to consider when deciding if a Roth conversion is right for you.
What is a Roth conversion?
One of the “catches” to the Roth IRA is that there are income thresholds that bar high-income earners from opening these accounts directly. In 2020, single-filers become ineligible when their Modified Adjusted Gross Income (MAGI) hits $139,000. Married filers are excluded at a MAGI of $206,000. It is for this reason that a conversion becomes attractive—they allow high-earners to take advantage of the Roth benefits.[i]
A conversion is when some or all of the funds from a traditional IRA are “rolled over” or “converted” to a Roth. This can be done through the financial institution where you hold your IRA or with the assistance of your financial advisor.
When Do I Owe Taxes on a Conversion?
Since withdrawals are made tax-free and taxed upon contribution, a conversion is a taxable event. This means that taxes will be due on the converted funds in the year the conversion is made. The key concern then becomes whether or not converting will actually save you money in the long-run. That is, will you pay lower taxes today with a conversion or by keeping funds in a traditional IRA and paying later?
Piecing this puzzle together isn’t always easy, though. There are a few questions that have to be answered to address this question:
- Will your tax liability be higher in retirement or higher now?
- Do you expect your income to increase significantly in retirement or decrease?
- Are you “tax-deferred rich”? Will all your retirement income be taxable?
- What can we anticipate the tax rates to be in the future?
Of course, none of us can predict the future, but we do know that the current reduced income tax rate will escalate again in 2025 when the 2017 Tax Cuts and Jobs Act is set to expire. This means, of course, that someone on the cusp or expecting to earn more income in the next five years could veritably be in a higher tax bracket at that time—a reason to consider a conversion now.
The Bottom Line
Roth conversions can make financial sense for individuals if it significantly lowers their tax liability or fills an estate planning need. Just because a Roth offers benefits that the traditional IRA doesn’t, does not mean that they are the right choice for everyone. As always, consult with your financial and tax professionals before making any major decisions.
If you want to learn more about a conversion or about our comprehensive retirement planning services, we encourage you to schedule a conversation with us today. We’d love to chat with you about how we help individuals and families prepare for a successful retirement.
[i] https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2020