COVID-19 Crisis Creates Silver Lining for Roth IRA Conversions
DEFER, DEFER, DEFER……Many of you have heard this expression when it comes to taxes. If you contribute money to a 401K, SEP IRA, or Traditional IRA to cut your taxes and save for retirement then you DEFER, DEFER, DEFER. All three of these retirement vehicles are designed to take the tax break now and you pay the taxes when you draw the money out with the idea….”that you’ll be a lower tax bracket later which in turn will SAVE YOU $$$$$. Traditional IRA’s started in 1974 and 401K’s took effect in 1980. All of these are good ways to save, but we want to make you aware of a problem we see at VTFM. When you file your tax return post retirement when you are supposed to be in a lower tax bracket. We see many retired taxpayers come in during tax preparation with multiple streams of income. Income sources might include pension(s), retirement account distributions, investment income, rental property income, 85% of their social security is NOW taxed, and your lower tax bracket went out the window like a James Dean cigarette. Those little seeds that you saved year over year have grown into a large tree and now the IRS is going to collect taxes on the whole tree as it gets distributed branch by branch.
In 1997 the Roth IRA came on the scene like a trendy new popstar, but those of us who love the band DEFER could not get into Roth’s new hit song “Pay Now Save Later.” In case you have not looked at the national debt in while, we are over 26 Trillion dollars in debt and we just pumped 3.5 Trillion dollars into the economy during the COVID-19 crisis. Taxes might be going up sometime in the future if you catch my drift.
Maybe your Financial Advisor has been mentioning to you about doing a Roth Conversion but, of course, you did not get around to it. The fallout from the COVID-19 crisis creates a once-in-a-lifetime opportunity for Roth IRA Conversions. You may be tired of wearing a mask, but you can at least put a mask on your retirement account by paying an affordable tax now and gain assurance against future tax rate increases.
Roth’s do have major benefits!
(RMD Benefit)
Withdrawals from a Traditional IRA must be taken at age 72, even if you do not need the money. Forget to take your Required Minimum Distribution from the account and the IRS is penalty is 50% of the distribution. Qualified Roth Withdrawals on the other hand are Federal Income Tax Free and usually State Income Tax Free too. The best part of a Roth is if you do not need the money…… YOU DON’T TAKE A DISTRIBUTION. You are not required to take the Required Minimum Distribution at age 72. This is also a good tool to pass on your wealth to your family as a Legacy when you pass away.
To be a Qualified Roth Withdrawal you need meet the following two requirements:
1. You opened your Roth IRA for over five (5) years.
2. You reached 59 ½, became disabled, or died.
Example: Five-Year Rule
You opened your first Roth IRA by making an annual contribution on April 15, 2017, for your 2016 tax year. The five-year clock started ticking on January 1, 2016 (the first day of your 2016 tax year), even though you did not actually make your initial Roth contribution until April 15, 2017.
You meet the five-year requirement on January 1, 2021. From that date forward, as long as you are age 59½ or older on the withdrawal date, you can take Federal-Income-Tax-Free Roth IRA Withdrawals— including withdrawals from a new Roth IRA established with a 2020 conversion of a traditional IRA.
Tax Brackets are currently low now
Though future taxes are uncertain we do know current tax rates are low due to the Tax Cuts Jobs Act. In fact, these tax rates might be the lowest you will see for the rest of your life, because the tax rates that were in effect before the TCJA come back into play for 2026 and beyond. And tax brackets could increase much sooner than 2026, depending on what the donkeys and elephants decide they need to do to recover the trillions of dollars the Federal Government is dishing out in response to the COVID-19 pandemic.
Doing ROTH IRA conversions means pulling money out of a Traditional IRA, or SEP IRA. This creates a taxable event (when you put the money in, you got a tax deduction, and now the that the money coming out, it is taxable income), but is not subject to early withdrawal 10% penalty. This might be the year to start converting your Traditional IRA to a Roth IRA, as your tax bill might be lower due to COVID 19. If this has happened for you, your marginal Federal Income Tax rate for this year might be lower than you expected—maybe way lower. A lower marginal rate translates into a lower tax bill. Yet be sure you plan, because if you convert a Traditional IRA with a large balance—say, several hundred thousand dollars $$$ or more, thus such a conversion would trigger extra taxable income, and you could wind up in the 32%, 35%, and 37% bracket. You may want to break the conversion down and do it over a few years.
A lower IRA balance from the stock market decline = lower conversion tax bill
Just a short time ago, your IRA was flying first class with a drink in its hand, extra legroom, and a less crowded restroom. Then the fasten seat belt sign came on, the COVID-19 turbulence shook the plane and your IRA dropped in altitude big-time. Some of it has come back, yet who knows if this rebound is sustainable. We do not like seeing someone’s retirement account head south with the oxygen mask hanging from the ceiling, wondering if they can even retire. But in a tax planning sense, a lower balance means a lower tax bill if you plan to change your traditional IRA using Roth IRA conversions. The market rebound on your investments will be the same whether it is in the Roth or stays in the Traditional IRA, and even better, the withdrawals will be Federal-Income-Tax-Free. If you leave your Roth IRA to your heirs, their withdrawals are Federally Tax Free too!
As mentioned earlier, the current maximum Federal Income Tax rate is currently “only” 37%. What will it be five(5) years from now? 39.6%?, 45%?, 50%?, 55%? Nobody knows, but it is a good solid bet it will not be lower than 37%.
The Big Picture
If you do Roth IRA conversions in 2020, you will be taxed at today’s “low” rates on the extra income triggered by the conversion.
On the (far bigger) upside, you avoid the potential for higher future tax rates (maybe much, Much, MUCH higher) on all the post-conversion recovery, future income and gains that will accumulate in your new Roth account.
That is because Qualified Roth Withdrawals taken after age 59½ are totally Federal-Income-Tax-Free, if you have had at least one Roth account open for more than five (5) years before your withdrawals are taken.
If you leave your Roth IRA to an heir, he or she can take Tax-Free Qualified Withdrawals from the inherited account—as long as at least one of your Roth IRAs has been open for more than five (5) years when their withdrawals are taken.
DEFER, DEFER, DEFER…….
Becomes “BITE THE BULLET NOW” with lower taxes and then PROSPER LATER!
This expression is used to talk about something that we don’t want to do, but we can’t avoid doing it. Because we don’t want to do it, we delay doing it. When we finally end up doing it, we use this expression, “to bite the bullet”.
Pay the TAXES NOW, which are likely lower THAN IN THE FUTURE, and then have your money TAX-FREE when you need it!
