It is an understatement to say that 2020 has been associated with trying times – rapidly increasing unemployment, unprecedented business losses, and fears associated with the COVID-19 pandemic. However, amidst the uneasiness of the current environment exists great planning opportunities for the future. One of these potential opportunities is the conversion of a traditional IRA to a Roth IRA.
Below are some reasons why taxpayers may want to convert an existing traditional IRA to a Roth IRA:
- Potential for investments to grow tax-free for a longer period of time
Traditional IRAs require taxpayers to take required minimum distributions (RMDs) every year after age 72, or age 70½, if attained before 2020. With a Roth IRA, mandatory distributions are not required; therefore, the money can remain in the Roth IRA and grow tax-free.
- Withdrawals in retirement are tax-free
Distributions from a Roth IRA are entirely tax-free if the withdrawals are made after age 59½ and it has been at least five years since the conversion. In contrast, distributions from a traditional IRA are taxable or, in some cases, partially taxable when nondeductible contributions have been made. Since qualified Roth IRA distributions are tax-free, it does not matter what the tax rate is at the time of distribution.
- Inheritance left to heirs will be tax-free
While the beneficiaries of Roth IRAs will be required to take RMDs, the amounts withdrawn will be tax-free, as long as the account has been opened for at least five years.
- Contributions can be made after age 70½
Taxpayers who are still earning eligible income after attaining the age of required minimum distributions may be eligible to continue contributing to a Roth IRA, depending on income limitations. With traditional IRAs, contributions cannot be made after this time.
There is a tradeoff when converting a traditional IRA to a Roth IRA. The deferred tax liability associated with the converted amount will need to be paid with the filing of the tax return in the year of conversion. The taxpayer could potentially face a large tax bill as a result of the conversion; however, future withdrawals from the account will be tax-free. The Tax Cuts and Jobs Act (TCJA) of 2017 prohibits recharacterization of Roth conversions, meaning conversions made after 2017 are permanent. Once the conversion is made, there is no turning back.
How do taxpayers know if it is a good time to convert a traditional IRA to a Roth IRA? If the value of the traditional IRA drops, such as during a pandemic, it may be a good time to convert to a Roth IRA, as the tax impact will be less than when the account is worth more. It may also be a good time to convert in a year when taxable income is especially low so the conversion amount will be taxed in a lower tax bracket.
A Roth IRA conversion may not be the right move for a taxpayer who anticipates a need to withdraw the retirement funds in the next five years. If distributions are made within five years of the conversion, it may be subject to a 10% penalty on the distributed amount, as well as income taxes on withdrawals of earnings.
The decision to convert to a Roth IRA should be made with the guidance and advice of a financial team, including a tax advisor. Windes can help with an analysis of the costs and benefits of conversion, allowing taxpayers to make a decision that is beneficial for the long-term.
If you have questions or would like more information, please contact Ashley Rivera at arivera@windes.com or 844.4WINDES (844.494.6337).