Waived 2020 IRA Required Distributions Present Possible Planning Opportunity
October 14, 2020
This year’s CARES Act exempts required annual distributions in 2020 for all IRA owners over age 70 ½, and for some people, this may create an attractive planning opportunity utilizing the Roth IRA conversion.
Unlike a traditional IRA that is funded with pre-tax dollars that grow tax deferred until withdrawn (as taxable income), a Roth IRA is instead funded with after-tax dollars and allowed to grow (and ultimately be withdrawn) fully tax free. Funds in a Roth IRA are currently not subject to any growth limit restrictions and there is no required annual distribution for a Roth as there is with a traditional IRA. Given its attractiveness, though, the IRS has limited the availability to contribute to Roth IRAs only to individuals with earned income at or below $139K in 2020 (or up to $206K if married filing jointly). However, the ability to convert an existing traditional IRA (or some portion of it) to a Roth is not restricted by any income limits. Despite the inherent benefits of the Roth IRA, there is one important factor to consider about making any such conversion; the amount being converted is treated as ordinary income in the year of the conversion.
Essentially, converting a traditional IRA (whether fully or partially) to a Roth is about paying taxes on retirement savings now rather than in the future. Therefore, some investors may benefit more than others if they have less taxable income in 2020 versus 2019 given their ability to forgo the normal required minimum distribution (RMD) this year. Plus, since many are already paying their 2020 estimated taxes based on 2019 income amounts (with safe harbor equaling 110% of the previous year), it might make sense to convert at least a portion of the IRA equal to what the 2020 RMD amount would have been. The ideal candidate for a Roth conversion in 2020 is someone who does not need to use their 2020 RMD and who will not see a material change in taxes owed from 2019 to 2020, given the tax impact of the Roth conversion.
In our view, 2020 might also be a relatively attractive time to convert to a Roth IRA because tax rates could climb in the near future given some campaign remarks; besides, the 2017 Tax Law is scheduled to sunset in the not-too-distant year of 2025. Lower market values also generally make a Roth conversion attractive—to move it over before future appreciation occurs—and while there has been a solid market rebound from earlier in the year, the recent volatility has put the major equity indexes (as of the end of Q3) not far from January 2020 values. Moreover, targeted transfers of securities that are still down in 2020 would be ideal candidates to convert. Furthermore, the SECURE Act of 2019 made changes to non-spouse inherited traditional IRAs that may create greater tax burdens than they did before, with heirs of these traditional IRAs now being required to fully withdraw over a 10-year period, rather than over their own lifetime. Granted, a Roth IRA’s inheritor must generally withdraw the entire account over a 5-year period, but those withdrawals are tax free as long as the account has been open for at least 5 years before the original Roth IRA owner’s death. Hence, an heir receiving some portion of their inherited retirement accounts in Roth form may have less tax burden in the decade following receipt.
While a Roth conversion may not be beneficial for everyone this year, it should be a topic discussed with your CPA and Wealth Manager during year-end planning. With 2021 fast approaching, the deadline for a 2020 Roth conversion is December 31st; however, custodians are usually extremely busy at year end, so we recommend initiating any possible conversion as soon as possible.
Source: https://www.irs.gov/retirement-plans/roth-iras
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