By: Daniel G. Mazzola
Early estimates peg the cost of the CARES Act, the package providing economic relief to Americans impacted by the COVID-19 pandemic, at $2 trillion. The government has run itself into an immense debt to give its citizens assistance, and the citizens in turn will be called upon to contribute their share to the public expense. Their share will be in the form of higher taxes. Individuals can insulate themselves from future tax rate increases and take advantage of the market downturn by converting their Traditional IRA into a Roth IRA in 2020.
Roth IRAs differ from Traditional IRAs in that there are no Required Minimum Distributions and withdrawals are tax-free. Taxes are triggered when a Roth conversion is implemented, as assets shifted from the Traditional IRA become taxable. It is as if an ordinary withdrawal is taken and the money pocketed. Why would anyone subject themselves to paying taxes before they would have to otherwise? Isn’t the idea of tax planning to avoid or at least defer tax liabilities as long as possible? The Roth conversion defies conventional tax planning for two reasons, one prompted by the current economic climate and one that weathers all seasons.
Steve is in the 24% tax bracket and has 1000 shares of Fund X in his Traditional IRA. As of 12/31/19, the account balance was $100,000. If he executes a Roth conversion on 1/1/20 his tax liability is $24,000. As of 5/8/2020, the account value is $80,000. A Roth conversion today costs him only $19,200. He is satisfied with his investment in Fund X and does not want to sell his shares. He can make a like-kind transfer whereby shares themselves are converted and his position remains intact. The shares are never “out of the market” and will appreciate tax-free when the stock market recovers. By converting now, he is allowed to transfer the same amount of shares but at a lower tax bite.
Liz is 69 and maintains a Traditional IRA. She will be forced to withdraw a specified percentage of the account starting at age 72. The Required Minimum Distribution starts at roughly 4% of the account and increases annually as her life expectancy decreases. She does not need this money! A Roth conversion allows her to control both the timing and amount of her withdrawals. RMDs have been suspended for 2020, which only reinforces the conversion strategy now. She will have to withdraw a greater amount in the future, to compensate for this year’s postponement, in a higher tax rate environment.
The conversion is especially appealing for those who intend to leave IRAs to heirs. As the law stands, designated beneficiaries have to liquidate an Inherited IRA in 10 years. A tax-free payout from a Roth IRA, compared with a taxable distribution from a Traditional IRA, results in a greater legacy.
Converters should be careful not to trigger higher taxes than necessary by ensuring the move does not place them in a higher tax bracket, raise Medicare premiums or increase the taxability of Social Security. It is also advised that the tax be paid on the conversion come from cash reserves on hand.
Given the complexity of the transaction, coupled with limited time and resources, you may find it challenging to determine if the strategy is appropriate. I invite and encourage you to contact me to ascertain if you and your family’s interests will best be served by a Roth IRA conversion.
Daniel G. Mazzola, CPA, CFA, is an investment advisory representative with American Portfolios Advisors Inc. He is a Chartered Financial Analyst, Certified Public Accountant and Certified Financial Planner. Mr. Mazzola is a member of the NYSSCPA Personal Financial Planning Committee. DANMAZZOLA.COM