With extraordinary government spending and the lowest tax rates we have seen in a generation, now may be the time to consider converting your traditional IRA to a Roth IRA. If you share our suspicion that tax rates will be higher in the future to pay for COVID-19 relief programs, you may benefit from converting to a Roth IRA. However, the clock is ticking with upcoming elections, briefly suspended rules, expiring tax laws and a stock market that resembles a rollercoaster.
A traditional IRA reduces current ordinary income through contributions in exchange for paying taxes when money is withdrawn. A Roth IRA does not reduce current income but allows tax-free withdrawals in the future. While conversions will increase current ordinary income, taking advantage of historically favorable income tax rates will build future wealth.
Setting the stage
The 2017 Tax Act brought historically wider income brackets and historically lower income tax rates. In 2020, a married couple earning $326,600 will be taxed at a historically low marginal tax rate of 24%. This same couple would have been trapped in a 33% marginal tax rate as recently as 2017. If the complexion of Congress changes after the 2020 elections, all bets are off on how long these lower rates can be exploited. While available, more income from a conversion can be absorbed at these relatively low tax rates.
To counter an unprecedented global pandemic, the federal government recently sank another $2-plus trillion into debt with the CARES Act. Perhaps Congress will do something about the debt burden in the near future by increasing income taxes. Increasing tax rates favor a Roth IRA since lower rates have been “locked-in” on contributions and earnings accumulate tax-free. By comparison, a traditional IRA forces the owner to recognize income when that national day of reckoning finally arrives at likely higher rates.
The CARES Act conveniently waived required minimum distributions (RMDs) for 2020. The waiver extends to an IRA owner over age 70 and also to those beneficiaries who inherited IRAs. An RMD essentially forces you to empty enough of your traditional IRA each year and pay taxes or face a steep penalty. For example, if you forgo your RMD in 2020 from your traditional IRA, your ordinary income will be lower, which might keep you in a lower marginal federal income tax bracket. A temporarily lower tax bracket makes a Roth IRA conversion even more cost-efficient by further suppressing ordinary income.
The current market
This would have been a far more persuasive argument back in March than it is today with the market recovery. However, we remain cautious that stocks could plummet again if there is a new wave of COVID-19 cases with states reopening. If the market drops, that means that there is a smaller amount of ordinary income recognized on the conversion of a traditional IRA to a Roth IRA. A smaller amount of taxable income recognized will reduce the income tax incurred when making the conversion to a Roth IRA.
The SECURE Act added a rule that most traditional IRAs inherited by non-spouses must be emptied within 10 years after the IRA owner’s death. Distributions will be taxed sooner and exposed to income taxation at possibly higher marginal tax rates when the RMD is added to the beneficiaries’ own income. Conversely, inheriting a Roth IRA permits the inherited Roth IRA to grow for 10 years, generating tax-free income, before having to be emptied on the 10th anniversary of the IRA owner’s death.
If Joe Biden is elected president, he has made it clear that he wants to reduce the federal estate tax exemption from $11-plus million to $3.5 million per person. Reducing the size of the IRA owner’s taxable estate through a Roth conversion might help heirs avoid paying federal estate tax. The income taxes paid on the Roth conversion will reduce the owner’s gross taxable estate. This could mean more wealth ultimately passing to their heirs if no federal estate tax is owed.
Even if there is no change in administrations after November’s election, a Roth IRA conversion still makes sense. The current low income tax rates and broadened income tax brackets are set to expire on Dec. 31, 2025, reverting to the 39% highest marginal income tax rate, along with the 3.8% net investment income surtax, and the dramatic drop in the federal estate and gift tax exemption to $3.5 million per person.
With the global pandemic and new legislation to mitigate its impact, an IRA owner may find themselves in a quickly diminishing favorable tax bracket. It would be disappointing to not take advantage of a once-in-a-lifetime opportunity.
Jeff Pauza, CFA, CFP is a Grand Rapids-based senior wealth management adviser for Greenleaf Trust. He specializes in the development of comprehensive wealth management plans, execution of goal-based planning strategies and management of client investment portfolios. George Bearup, J.D., is a senior trust adviser. He has 46 years of practical experience as an estate planning attorney with experience in estate, fiduciary and tax law. Jeff can be reached at firstname.lastname@example.org.