Is Now the Time to Convert Your Traditional IRA into a Roth IRA?

One topic that most of us can agree on is that 2020 has been very trying and has brought economic challenges to many.  Due to business disruptions, the income of many taxpayers will be reduced this year.  While no one is happy with reduced income, a reduction in taxable income may present a planning opportunity.

Individual Retirement Accounts: Pre-Tax or After-Tax?

Individual retirement accounts (“IRAs”) are a means for individuals to defer income taxes.  The two most common types of IRAs are traditional and Roth.  Traditional IRAs are funded with pre-tax dollars.  Tax is paid at the time of distribution.  Roth IRAs are funded with after-tax dollars which means distributions from a Roth account are tax-free.  

 “A combination of investment income, social security, pensions, and retirement withdrawals may result in a much higher tax bracket at retirement than originally anticipated.“

Many individuals choose to contribute to a traditional IRA because of the assumption that their current tax bracket is higher than it would be at retirement.  This is not always the case.  The more you save over time, presumably the more income you can expect to have in the future.  A combination of investment income, social security, pensions, and retirement withdrawals may result in a much higher tax bracket at retirement than originally anticipated.  

With the possibility that your tax bracket may be as high or higher in retirement than now the option exists to convert your traditional IRA’s to Roth IRA’s today. When an individual converts a traditional account to a Roth, the converted amount is taxed at today’s tax rates.  Low tax rates and reduced taxable income make this an excellent time to take advantage of this opportunity. The conversion is done with the expectation that today’s tax on the conversion will be lower than the tax when minimum distributions will be required in the future.  Taxes are typically withheld at the time of conversion by your broker or, you can elect to pay the taxes using another funding source.  

Tax advantages to a Roth conversion.  

Reducing the income tax paid on distributions is just one possible benefit of converting to a Roth IRA.  Other advantages of a Roth IRA over a traditional IRA that you can realize during your lifetime are:

1. Roth IRA’s have no required minimum distributions during the account owner’s lifetime.  
2. Growth in the account is tax-free. 

Both of these aspects allow you to leave money to your heirs that can be enjoyed income tax-free.  

Secure Act of 2020 Requires a 10-Year Withdrawal for All IRAs

The Secure Act, which became effective in 2020, requires beneficiaries other than the deceased’s spouse to take distributions over a ten-year period. Prior to 2020, non-spouse beneficiaries could take distributions over their lifetime. (Note: spousal beneficiaries may still take distributions over their expected lifetime). 

The condensed 10-year timeframe for withdrawals could result in higher tax brackets for a non-spouse beneficiary of a traditional IRA, which could make the conversion to a Roth IRA a better option for your heirs.

Weigh the Penalties Before Converting an IRA

There are some disadvantages to consider before making a conversion.  Any amount withdrawn from an IRA before age 59 ½ is known as an early distribution.  Generally, a 10% penalty is assessed on early distributions unless certain exceptions are met.  A Roth conversion is one of the exceptions, however, any amount not converted to the Roth is considered a regular distribution.  This means the amount withheld for taxes, if you so choose, is considered a regular distribution subject to the 10% penalty.  In addition, the 10% penalty applies if you take a distribution within five years of the conversion and the account owner is still under age 59 ½ and no exception applies.  

Low current tax costs for converting plus the opportunity to avoid higher future tax rates on income and gains accumulated in your IRA may make a conversion beneficial.  Deciding whether the conversion is the right choice is a complicated decision.  As always, we recommend that you speak with a trusted advisor before making any decisions. This is your future and we are always available to work with you.

DISCLAIMER: The WM Daily Update COVID-19, COVID-19 Business Resources and COVID-19 Client News Alerts and other related communications are intended to provide general information on legislative COVID-19 relief measures as of the date of this communication and may reference information from reputable sources. Although our firm has made every reasonable effort to ensure that the information provided is accurate, we make no warranties, expressed or implied, on the information provided. As legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that may modify some of the provisions in this communication. Some of those modifications may be significant. As such, be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed.