To Convert or Not to Convert? That Is the Question!
| Steve Carlson
What am I talking about, you ask? Roth conversions.
What is a Roth conversion? A Roth conversion is taking all or part of an existing traditional IRA and moving it into a Roth IRA. The main difference between a traditional IRA and a Roth IRA is that traditional IRAs grow using pretax income and are taxed when the money is withdrawn, while Roth IRAs are funded with after-tax income and are tax-free at the time of withdrawal, as long as you meet certain requirements.
Why would an investor convert their traditional IRA to a Roth IRA?
There are several reasons someone would want to convert their IRA to a Roth IRA. First, Roth IRA contributions and earnings grow tax-free. Second, you can withdraw your contributions (not earnings) at any time tax-free (Earnings are subject to the five-year rule). Third, Roth IRAs are not subject to Required Minimum Distributions (RMDs).
When should an investor convert their traditional IRA to a Roth IRA?
For the purposes of this blog, let’s focus on the tax part. When you convert your Traditional IRA to a Roth IRA those contributions, and any investment gains, will be added to your taxable income when you file your tax return for the year. So, is it possible to TIME your conversion in such a way that the taxes you’ll owe on the conversion will be less? YES!
How can I time my conversion to achieve a lower tax bill?
- Stock Market declines: When the stock market has declined, most likely your IRA balance has declined. Therefore, the balance you are converting to a Roth IRA will be lower, hence, the taxable event is lower. Less taxes!
- Lower Income: Sometimes your taxable income is lower than normal which may bump you into a lower tax bracket. If you convert to a Roth IRA that year, the percent you pay in taxes may be lower.
This year might be the perfect storm of opportunity. The stock market has declined, and while painful, it does mean a Roth conversion could be completed in a tax-efficient way. Plus, if part of your taxable income normally comes from RMD from your traditional IRA, this may be the year to execute a Roth conversion. The CARES Act has suspended RMDs for the tax year 2020. If you would have had a RMD obligation for 2020, you do not have to take your RMD if you don’t want to. This means your taxable income, if you choose to skip RMD, may be significantly lower!
A strategy for success!
APC’s strategy is to minimize your taxes by ‘filling the lower tax bracket bucket’. Our income tax system is structured like a series of buckets suspended one on top of the other. A taxpayer fills one bucket, the top and lowest tax rate, by earning income until it overflows into the next, higher tax bucket. The first two buckets are relatively low at 10% and 12%. The next bucket has a bigger jump up, to 22%. Therefore, a good strategy is to try to fill the first two lower ‘buckets’ without spilling over into the larger 22% bucket. This means the tax year 2020 may be a good time to consider a Roth IRA conversion to help reduce taxes in retirement and leave a tax-free inheritance to your heirs!
*Please talk to your tax advisor prior to making an investment decision. This is for informational purposes only and is not to be construed as investment or tax advice. Roth conversions have unique restrictions, such as the aggregation rule, to be aware of prior to making any decision.