Financial Planning

A Great Year for a Roth Conversion

Tax advisors say you can reduce your tax bill by 30% to 40% in this unprecedented time.

Two events — a crashing stock market and the waiver of required minimum distributions in 2020 —have unexpectedly created an ideal time to convert retirement savings from a traditional individual retirement account to a Roth IRA. Unlike traditional IRAs, withdrawals from a Roth are tax free in retirement. The catch is that federal and state taxes are owed on the conversion amount for the year the conversion is made.

Those taxes, however, have just gotten more affordable. With the Dow Jones Industrial Average down 14% in the first four months of 2020, a shrunken retirement savings portfolio has less to tax.

For retirees with other sources of income, there’s the added bonus of skipping a 2020 required minimum distribution, an option the CARES Act allows only for this year. The waiver applies to RMDs from all traditional individual retirement accounts, including inherited IRAs, as well as defined contribution plans such as 401(k)s. In any other year, those distributions, which are mandatory at age 72 and taxed as ordinary income, would only add to your tax burden. Retirees who don’t need their 2020 RMD should consider converting to a Roth an amount equal to that waived distribution.

“This year is an unprecedented opportunity,” says Maria Erickson, a financial advisor at Freedom Financial and Business Planning in Tampa, Fla. “The numbers are pretty compelling. You can reduce your tax bill by 30% to 40%.”

The Case for High Earners

For people nearing retirement who are typically in their highest earning years, Roths are tantalizingly attractive savings vehicles that can seem frustratingly out of reach.

For one thing, not everyone can contribute to a Roth. Some high earners and people with no earned income cannot contribute at all. (Anyone else can contribute $6,000 in 2020, or $7,000 for those age 50 and over.) The Internal Revenue Service bases eligibility on your modified adjusted gross income and tax filing status.

If you are single and your MAGI exceeds $139,000, or $206,000 if you’re married and file jointly, you can’t contribute to a Roth IRA. But there are no income restrictions on contributions to traditional IRAs, nor are there any income limits or earnings requirements for Roth conversions. That means you can contribute to a traditional IRA and convert it to a Roth, a strategy known as a “backdoor” Roth IRA.

Even for high earners who are eligible to contribute, Roths aren’t always better. Financial advisers typically recommend Roths for individuals who expect to pay higher taxes in retirement. Because Roths are funded with after-tax dollars in exchange for tax-free retirement withdrawals, there are no tax breaks for contributions. In the past, the ability to reduce current taxable income by contributing pre-tax dollars to a traditional IRA typically has been of greater value to high earners, whose incomes usually fall in retirement anyway.

Then in 2017, Congress slashed tax rates to their lowest levels in decades. Unless Congress intervenes, those rates will sunset at the end of 2025. The U.S. national debt is currently at record levels, $24.7 trillion as of April 23, 2020. As Congress passes more relief measures to combat COVID-19 and a devastating recession, the debt is only expected to rise, increasing the odds of tax rates rising after 2025, too. That makes the case for converting to a Roth now even more compelling for high earners, who may pay higher taxes beginning in 2026.

Other Benefits to Consider

Tax-free withdrawals in retirement aren’t the only advantages Roths offer. In fact, their benefits compared to traditional IRAs have only grown in the past year.

One of the biggest boons: Roths have no RMDs, although they are required for beneficiaries other than a spouse. If you don’t need the money, you can leave the funds intact for your heirs, who now get a better deal with an inherited Roth compared to an inherited traditional IRA. Until Congress passed the SECURE Act last year, nonspouse beneficiaries of either a Roth or traditional IRA could “stretch” the accounts by taking distributions based on their life expectancy, but beginning in 2019, that option ended. Now those beneficiaries must withdraw all the money from either a regular or Roth IRA account within 10 years. The difference, though, is that withdrawals from an inherited Roth are tax free.

Unlike traditional IRAs, Roth IRAs also enable you to tap contributions free of taxes and penalties at any age for any reason. You can begin withdrawing earnings at age 59½ provided you have had the Roth account for at least five years. Otherwise, you will pay a 10% penalty for early withdrawals and be taxed on the earnings.

How Much Should You Convert? 

Two things may determine how much you can afford to convert from a traditional to a Roth IRA in a given year: the effect on your tax rate and the means for paying the taxes on the conversion amount.

Because the conversion amount is added to your taxable income, it could potentially bump up your tax bracket. To stay within the same tax bracket, the most you could convert is the difference between your current tax bracket’s highest end and your pre-conversion taxable income. So, for example, a married couple filing jointly in 2020 with a taxable income of $100,000 pays 22% in taxes and can convert up to $71,050 without hitting the next tax bracket, which begins at $171,051 and is taxed at 24%. 

You can also spread out the amount you want to convert over several years to minimize the tax impact, which can be painful. That same couple that converts $71,050 could potentially owe $15,631 on the conversion amount if they have only made deductible contributions to any traditional IRA they own.

If you have also made nondeductible contributions over the years, the tax bill isn’t a straightforward percentage based on your income. Instead, you will need to calculate which portion of those contributions were deductible and nondeductible for every traditional IRA you own, not just the one being converted. Inherited IRAs are excluded from this equation. 

The IRS doesn’t want you to pick and choose which types of contributions are used for the conversion. Instead, a ratio of pre-tax to after-tax assets for all IRA accounts is used to determine how much of the contributions should be taxed. Earnings, of course, are always taxed. You may want professional tax help to determine what you will owe before deciding how much to convert. 

If you have a regular 401(k) and are retired, the IRS allows you to roll over (not convert) only after-tax contributions directly into a Roth IRA, eliminating the tax bill on the rolled-over amount.

Keep in mind if you pay the taxes for a Roth conversion using money from an IRA, the IRS considers the portion used for taxes a distribution. In that case, taxes and a 10% penalty, if it’s an early withdrawal made before age 59½, will apply. Whenever possible use savings from a nonretirement account to pay the taxman.

Most Popular

The Perfect Storm for Retirees
retirement planning

The Perfect Storm for Retirees

Today’s retirees could face a perfect storm because they are living longer and spending more time in retirement, while at the same time losing access …
April 18, 2021
The Wrong Way to Achieve Wealth
personal finance

The Wrong Way to Achieve Wealth

For some down-to-earth, basic advice on money and life, I have a book to recommend: “Your Total Wealth: The Heart and Soul of Financial Literacy.”
April 17, 2021
Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs
Coronavirus and Your Money

Child Tax Credit 2021: Who Gets $3,600? Will I Get Monthly Payments? And Other FAQs

People have lots of questions about the new $3,000 or $3,600 child tax credit and the advance payments that the IRS will send to most families in 2021…
April 14, 2021


10 Questions Retirees Often Get Wrong About Taxes in Retirement

10 Questions Retirees Often Get Wrong About Taxes in Retirement

You worked hard to build your retirement nest egg. But do you know how to minimize taxes on your savings?
April 7, 2021
6 Money-Smart Ways to Spend Your Third Stimulus Check
Coronavirus and Your Money

6 Money-Smart Ways to Spend Your Third Stimulus Check

If you don't have to use your third stimulus check for basic necessities, consider putting the money to work for you. You'll thank yourself later.
March 20, 2021
Is Now the Right Time for You to Make a Roth Conversion?
Roth IRAs

Is Now the Right Time for You to Make a Roth Conversion?

Timing is everything with Roth IRA conversions. Whether it’s the right time for you depends on where you are in life. Are you still working? Retired? …
March 18, 2021
The Basics of Required Minimum Distributions: 12 Things You Must Know About RMDs
Financial Planning

The Basics of Required Minimum Distributions: 12 Things You Must Know About RMDs

Retirement savers who are 72 must start withdrawing funds from tax-advantaged retirement accounts. Here’s what you need to know about required minimum…
March 4, 2021