While we hope for an end to the current coronavirus pandemic, there may be a silver lining for retirement savers during this time of disruption. If you can manage doing a Roth IRA conversion, you’ll likely pay a lot less to do it now.
Why? For a few reasons. Many people will find themselves in lower tax brackets in 2020, either because of the loss of income from a job layoff or, for retirees age 72 or older, because the CARES Act allows them to skip their taxable required minimum distributions from their retirement accounts for 2020. (For more on that, please read A Hidden Benefit of the Coronavirus Stimulus Bill: You Can Wait to Take Your RMD.)
In addition, many of these same people own stocks in their company retirement plans or IRAs that are down in value due to the recent severe market drop.
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A Golden Opportunity
This confluence of circumstances creates a golden opportunity to pay less in taxes when converting a pre-tax IRA to a tax-free Roth IRA (or when converting a pre-tax 401(k) to a Roth 401(k), if the company allows it). When the market rebounds, anyone owning stocks in their IRAs will, in effect, be getting their Roth IRA at a bargain price.
For example, let's say you have a pre-tax IRA invested in stock mutual funds that were valued at $30,000 at the market peak in February of this year. And today the value is $24,000. Let’s also assume you are married filing a joint return and have reduced taxable income either through a job layoff and/or because of the suspension of your RMD.
To make it an even sweeter scenario, let’s say that this reduction in your income reduces your tax bracket from 22% to 12% with projected taxable income of $55,000 for 2020. You can convert the $24,000 pre-tax IRA to a Roth IRA and pay tax on $24,000 in a 12% bracket instead of your former 22% bracket.
The end result is that it would cost you $2,880 in taxes to do the Roth conversion instead of the $5,280 it would cost you in the 22% bracket. And if the market rebounds to its pre-crash level your IRA is now worth $30,000 again.
If this happens, the end result will be you get what equates to an extra $6,000 in your Roth IRA without paying any taxes on it. And from there on out, your Roth IRA grows tax-free, there are no capital gains taxes to pay and all your qualified withdrawals will be tax-free as well. That’s a pretty good deal.
Tax Rates Going Higher
The time to make these extra-cheap conversions is limited, however. Longer-term tax rates are likely to be higher than where they are now, making future Roth conversions more expensive if you wait too long. One reason for this is because our current, more favorable tax brackets are scheduled to expire after 2025 and return to 2017 levels, with five of the seven tax brackets going higher.
In addition, our current deficits and the recent $2 trillion-dollar-plus Coronavirus stimulus package will also add to the upward pressure on tax brackets, as the government looks for sources of tax revenue to pay these deficits down.
Return Those RMDs
If you already took your required minimum distribution for 2020, or what you thought was your RMD, and you don’t need the money, you may now wish to return it since they are not required for this year. Then, if it makes sense, the money could be used in a far more tax-efficient way, by converting some or all of it to a Roth IRA.
There are two possible ways to put the RMD back:
- The most certain way is if the RMD distribution took place within the last 60 days and you haven’t already done your one IRA rollover that you’re allowed to do for each 365-day period. In this case you can simply write a check for the RMD amount and put it back into the IRA before the end of the 60-day rollover period.
- If you took the RMD very early in the year and you have gone past your 60-day rollover window there is still another possible approach to put it back. If you can show that you have been impacted by the COVID-19 crisis enough to qualify under the liberal guidelines for the withdrawal of up to $100,000 under the recently passed CARES Act, this would allow you to put up to $100,000 of your RMD back into your IRA.
Lemons or Lemonade?
While it’s everyone’s hope to see the coronavirus come to an end and stocks to go back to their previous highs and beyond, in the meantime a carefully planned Roth conversion this year may be a way to turn lemons into lemonade.
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