Covid-19 and the CARES Act Enhance the Roth Conversion Game

Michelle Barron |

Has the Covid-19 stock market volatility caused your retirement accounts to decline? Will the temporary suspension of required minimum distributions (RMD) or a reduction in your compensation lower your 2020 tax liability? Do you think the significant increase in the federal deficit creates the possibility for future tax increases?

With the combination of the lower 2020 tax liability, the possibility of future income tax increase, as well as potentially lower portfolio values, current circumstances created a game-changing environment. The financial planning strategy utilizing Roth conversions could look attractive for those looking to game future cash flow taxation.

Just a quick refresher of the essential characteristics of the traditional and Roth IRAs:

Traditional IRA

  • Contributions are tax-deductible.
  • Growth inside the account is tax-deferred.
  • Qualified distributions are taxed as ordinary income.
  • Required minimum distributions (RMD) typically start at age 72.

Roth IRA

  • Contributions are not tax-deductible.
  • Growth inside the account is tax-free.
  • Qualified distributions are tax-free.
  • Required minimum distributions (RMDs) are not required.

Roth IRAs can be an essential part of retirement and estate planning and not just when funding retirement accounts. The conversion allows you to change a traditional IRA to a Roth IRA and game when you or your beneficiary pays taxes. You can convert all or any portion of your traditional IRA. Taxes will be calculated and assessed based on the year in which you make the conversion. This should be a significant consideration. Any amount converted from a traditional IRA to a Roth IRA is added to your income and is taxed as ordinary income.

Switching a considerable amount from a traditional to a Roth can quickly move you into a new tax bracket. Strategically converting a portion of your traditional IRA, may make more sense. This is especially so if you anticipate that you will be in a higher tax bracket during retirement or if your ultimate beneficiary will be in a higher tax bracket within 10 years following an inheritance.

Having a plan to pay for those taxes is also essential. In the ideal situation, you should have the ability to pay for the taxes with funds outside your retirement accounts to get the most bang for your buck. If you do not have resources available to pay your tax obligation, and your only way to cover your liability is through funds from your IRA, you can have the funds withheld during the conversion.

However, you will have less money working for you, either tax-deferred or tax-free. It is important to note that the amount withheld for taxes is included when determining your taxable income and will also be subject to the ordinary income tax rates.

Many people are attracted to the tax-free distributions that are provided by the Roth IRA. Let's be honest everyone likes free, yet nothing is ever that simple, especially tax provisions coming from the IRS.

The Roth IRA's tax advantages of tax-free growth do not come without qualifications, one of which is a waiting period called the five-year rule. The five-year rule states that a Roth needs to exist for five years before you qualify for a tax-free withdrawal, but unfortunately, it's not exactly that simple. The five-year regulation can get tricky as it is applied differently depending upon the circumstance.

As the provision relates to conversions, each conversion has its own five year period of time that begins with Jan. 1 of the year in which you made the conversion. If you do end up taking money before the five years is complete, the IRS treats the order of withdrawals for Roth IRAs to starts with contributions, followed by conversions and then earnings.

If you are under 59.5 and take a distribution of profits within the five years, you will be subject to a 10% penalty without an allowable exception on the amount you converted (i.e., you cannot do a Roth conversion to avoid the 10% early withdrawal penalty). Having enough planned cash flow to cover your needs for the next five years is critical when considering converting.

While financial planning strategies exist and can be profitable, they are not one size fits all. Current events may have made Roth conversions more appealing for some; it is still not the right decision for everyone. Keep in mind; these planning strategies are based upon current retirement plan rules and income tax legislation, which could change in the future. The decision for conversion should be based on each individual's circumstance and should consider reasonable assumptions.

If you need some help sorting through what considerations you should be thinking about, we are happy to talk to you through a no-obligation complimentary consultation.  E-mail us at info@rivercitywealth.com or call 904-374-9098.

This material is provided as a courtesy and for educational purposes only.  Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.