Consider a Roth IRA conversion ‘lemonade’ made from COVID-19 ‘lemons’

Due to a combination of recent Congressional acts, there are ample reasons to consider converting all or a portion of your traditional IRA to a Roth IRA in 2020.  Here are a few thoughts on this strategy and the rationale behind it.  As with any important financial decision, be sure to first consult with your qualified tax and financial planning professionals prior to acting.

Reason 1:  CARES Act suspends the need for 2020 Required Minimum Distributions (RMDs)

 

For IRA account owners already over 70 ½ years of age by 1/1/2020, the IRS would typically require a 2020 minimum IRA distribution (RMD) based on the 12/31/2019 closing account value and the account owner’s attained age.  Prior to COVID-19 related CARES Act, an income withdrawal ordering rule mandated that these required distributions be made first to a taxable account or qualified charity.  In other words, anyone interested in doing a Roth conversion would need to first satisfy withdrawing their mandatory distribution.  The CARES Act suspended the RMD need for 2020 which now frees up the ability to consider a Roth conversion.  Most IRA account owners were already planning to incur RMD related income for 2020.  Presuming that income was not budgeted for essential spending or otherwise needed to supplement household income, this CARES Act provision in effect supplies opportunity to convert one’s traditional IRA to a Roth, thus preparing to benefit from it as a future tax-free income source.  Too, once the principal is held in the Roth IRA, RMDs do not apply.  Thus, for account owners over 70 ½, the Roth may also be treated as a means to accumulate principal in an efficient tax-free manner.  

 

Takeaway:  Most RMD aged IRA holders expected to receive taxable RMDs in 2020 anyway.  Repurpose that income when not needed for spending as a Roth conversion to provide future tax-free income and growth.

 

Reason 2:  Your IRA balance may be lower this year given the market volatility

 

On the heels of the S&P 500 index returning more than 30% in 2019, COVID related market declines in 2020 may likely have reduced the current market value of stock holdings.  By taking advantage of this decline through a Roth conversion, the converted balances will be marked down in price at a discount.  Thus, your income realized by converting the shares at lower prices could serve you well in the future.  To illustrate, consider a hypothetical stock value peaked at $250,000 and now has declined to be worth $200,000, a 20% decline.  If the Traditional IRA owner converted that $200,000 in securities to a Roth IRA and realizes that all as taxable income, then the account value rebounds to its past $250,000 market value by appreciating 25%, the $50,000 in Roth IRA gains is considered a tax-free return within and upon distribution from the Roth IRA, provided certain time related holding periods are met for people under 59 ½.  

 

Takeaway:  Markets are down, so consider less taxable income will be realized upon conversion.

 

Reason 3:  Current tax rates will likely sunset (later) or be repealed (sooner)

 

Remember that the government allows us the privilege of pre-tax 401k payroll deferrals or tax-deductible traditional IRA contributions, yet it retains the right to tax these account distributions at prevailing rates down the road.  The Tax Cuts and Jobs Act of 2017 lowered marginal tax bracket rates, expanded most bracket income thresholds, and increased standard deductions.  Given that income tax rates are now at historically very low levels, coupled with a burgeoning federal budget deficit, it stands to reason that tax rates will revert to higher levels regardless of the upcoming presidential election outcome.  If President Trump is reelected, the expectation is the 2017 Act will automatically sunset after 2025.  By contrast, a Vice President Biden victory presents the expectation that current tax rates will be replaced, returning to higher levels through a repeal of the 2017 Tax Act.  As this relates to a Roth conversion in 2020, odds are you are now realizing taxable income at preferential rates relative to future ones.  Especially if an investor has a majority of his or her assets in tax-deferred accounts, StrongBox Wealth suggests to not end up beholden to future income tax rates and thresholds.  By diversifying one’s future income sources through the inclusion of a tax-free Roth account, an investor achieves a degree of future tax flexibility and control by providing beneficial income sequencing options applying at future prevailing rates.  

 

Takeaway:  Traditional IRA principal will be realized sooner or later as taxable income, so consider a partial Roth IRA conversion now while rates are near historic lows.

 

Reason 4:  SECURE Act reduced beneficiary IRA stretch distribution duration to ten years

 

With all the health and economic related upheaval caused by COVID-19 in 2020, it is easy to be distracted from long term strategic financial planning.  Prior to the 2019 SECURE Act, both spousal and non-spousal beneficiaries were able to “stretch” the distribution of inherited IRAs based on life expectancy tables.  For many, this allowance provided a tax deferred IRA account continuation opportunity for multiple generations.  The SECURE Act curtailed stretch provisions for non-spousal IRA beneficiaries to require account depletion through distributions made within a maximum 10 years.  Not only does this change accelerate taxable income required to be realized by the IRA beneficiary, but it also serves as a disincentive for long-term tax-deferred growth of traditional IRAs for both the original IRA owner and its beneficiary.  By converting all or a portion of a traditional IRA to a Roth IRA, the account principal has more time to grow tax-free.  Considering that the 10-year distribution also applies to inherited Roth IRAs, a dual benefit exists in that the Roth beneficiary could feasibly wait until the 10th year to withdraw all the inherited Roth IRA account balance completely tax-free.  Considering this requirement, IRA owners should review family circumstance and consider whether leaving a tax-free Roth IRA inheritance or a tax-deferred taxable traditional IRA is more ideal for the next generation. Especially if the ultimate non-spousal beneficiary is a high-income earner in or around the top tax bracket, an inherited traditional IRA could serve as a tax albatross.  

 

Takeaway:  Consider leaving a tax-free Roth IRA inheritance.

 

Reason 5:  Donate non-IRA cash or appreciated stock to offset Roth conversion related taxable income 

 

Pairing your charitable giving with a Roth conversion in the same year produces a very strategic complementary approach.  For many, with the effectively doubled standard deductions resulting from The Tax Cuts and Jobs Act of 2017, many taxpayers are left unable to deduct their charitable deductions.  Although giving to one’s preferred church or favorite non-profit organization is not usually primarily tied to a desired tax deduction outcome, it is always a beneficial circumstance when applicable.  When itemizing deductions, a taxpayer may include charitable donations of cash or capital assets.  Typically, a taxpayer may deduct cash donations dollar for dollar up to 60% of adjusted gross income (AGI), while deducting up to 30% of AGI dollar for dollar when using capital asset fair market values.  In other words, donating appreciated common stock to charity carries a dollar for dollar deduction up to 30% AGI while dually serving to avoid paying capital gains tax on the gift.  Thinking strategically with a comprehensive planning mindset, the ongoing need to own a properly balanced portfolio may be enabled by gifting portions of appreciated stock positions rather than selling which results in capital gains taxes.  Often, donors use donor-advised funds (DAF) to “bunch” a few years’ worth of charitable deductions into the current year to ensure an itemized tax return by exceeding the standard deduction, thereby maximizing material tax deductions.  This donor advised fund then serves as the vehicle by which one’s preferred nonprofit organizations are funded in future years.  In the interim prior to depletion from ongoing grants, the DAF grows tax-free like a Roth IRA.  With a donor advised fund established and multiple years of charitable contributions made from non-IRA assets, Roth conversion income is now positioned to be realized and offset.  In effect, you can have your cake and eat it too by tax efficiently repurposing assets through funding a donor-advised fund the year in which a Roth conversion also takes place.  The Roth conversion taxable income is offset by the deduction of the donor-advised fund contributions and results in two tax-free account sources to use in one’s financial and income planning.  The donor advised fund account provides funding to an investor’s chosen values based nonprofit organizations while the Roth account provides the IRA owner or his ultimate beneficiaries with tax free income and/or capital.  

 

Takeaway:  Donate non-IRA cash or appreciated stock into a donor advised fund to offset Roth conversion incurred taxable income.