With the stock market down due to the present COVID-19 crisis, it’s a great time to consider a Roth conversion if you have assets in a traditional IRA (where contributions were made on a pre-tax basis), and we will show you why.
Before we dive into important Roth conversion considerations, let’s have a quick review of the differences between a traditional IRA and a Roth IRA by looking at the chart below.
What is a Roth conversion?
A Roth conversion is when you move assets from a traditional Individual Retirement Account (IRA) to a Roth IRA. You must pay income taxes on the value of the assets converted, but the Roth IRA grows tax free from that point forward
Why make a Roth conversion?
1. The tax savings over your lifetime can be huge.
2. Roth IRAs give you the ability to pass an income tax free asset to your heirs.
3. You can take advantage of lower stock values in the present market with tax-free growth as discussed further below.
Why is it a great time to consider a Roth Conversion?
1. Recent stock market declines mean that many IRA’s have lower balances. Converting now will allow you move assets to a Roth at a lower tax cost, and when the economy recovers the Roth IRA and any future growth within the Roth IRA will be tax free. For example, if you had a $10,000 IRA at the end of 2019 and you took a 25% hit during the market downturn, you would now have $7,500. If you convert it to a Roth now it will generate only $7,500 in taxable income – a 25% discount compared to the beginning of the year. If the account recovers back to the $10,000 you will have converted your traditional IRA at a 25% discount. Now you you have $10,000 once again, but it’s in a tax free account which will continue to grow income tax free.
2. We presently have historically low income-tax rates. Furthermore, with the significant Government spending during the current crisis it is very likely that future income tax rates will be higher.
3. For some of you, your income – and resulting tax bracket – may be lower due to unemployment or under employment during the COVID-19 crisis. You can take advantage of low income years by converting IRA’s to Roth IRA’s while you are in those low brackets.
4. The recent SECURE Act changed inherited IRA distribution rules (as discussed in our previous article here). Previously, an individual who inherited an IRA could take distributions over his or her lifetime. However, now an heir must take the distributions in full within 10-years . For example, with a $500,000 inheritance, an heir would need to take $50,000 of income per year for each of ten years, which could throw them into a higher tax bracket and create a significant tax bill for them. However, if the same individual inherits a Roth IRA, all distributions are tax-free.
How much money should I convert from traditional to Roth?
There are several factors to consider when deciding on how much to covert.
1. Consider the tax bracket you are presently in. For example, if you are in the 24% bracket, you would ideally not want to convert so much that it bumps you up to the next bracket at 32%. It is often a good strategy to convert a small amount of your IRA each year, filling up your current tax bracket during retirement.
2. Consider you time horizon of when you need to use your IRA funds. For example, you would ideally want to have a longer-term time horizon to let it grow tax free and offset the current year hit for the taxes you pay on conversion. If you for example, convert $10,000 this year but need to withdraw it in only two years, it’s not going to make sense to take the tax hit now versus two years from now. (Note that for first time Roth conversions and contributions, you need to wait five years before withdrawing the funds).
3. Consider how you will pay the taxes on the conversion amount. Do you have the cash or assets to pay the taxes?
In conclusion, we at Cedarstone Advisors would be happy to help you figure out if a Roth conversion is right for you. We can prepare calculations to show you:
an ideal amount to convert without bumping you up to the next tax bracket,
the projected lifetime tax savings of making the contribution,
and the current year tax impact of making the conversion.
Let us know if we can help.