Reasons To Consider a Roth Conversion Now

In order to retire early in the style to which we have been accustomed, we had to develop a considerable nest egg. Our money has to last for the next 30 to 40 years and fund our roving retirement lifestyle. Therefore, I spend a considerable amount of time thinking about and managing our money.

The COVID crisis and recent legislation have increased the potential benefit of converting some funds now from a Traditional IRA to a Roth IRA for a wider swath of taxpayers. In this post, I present some reasons to consider whether this might be right for you or your parents.

Disclaimer

I am not a tax professional. Please consult one before taking any action on the ideas presented below.

Background

Briefly, a Roth Conversion is when you convert funds from a Traditional IRA into a Roth IRA. I look at taxes as a liability that extends through a lifetime and beyond to one’s heirs. My goal is to minimize that liability while maximizing potential returns on my funds. A key factor is thinking about what your income and the resulting personal tax rate will be over your lifetime. You can use that analysis as a guide for when you want to recognize income via a Roth Conversion and pay taxes at a favorable rate.

In Roth IRAs and Living Chapter 2, I cover some of the benefits of Roth Conversions. Here, I look at reasons why doing a Roth conversion now may be a good idea.

The 2017 Tax Cuts

Your Federal Tax Rate is a function of your income, deductions, and whatever the government feels like setting the tax rate to at that time. The Tax Cuts and Jobs Act of 2017 reduced business taxes going forward and personal taxes through 2025. So, through 2025, we have an opportunity to pay taxes at a historically favorable rate.

Taxes for Married filing jointly

Prior to	2018	Until 2026	(adjusted for inflation)
10%	$0–$19,050	10%	$0–$19,050
15%	$19,050–$77,400	12%	$19,050–$77,400
25%	$77,400–$156,150	22%	$77,400–$165,000
28%	$156,150–$237,950	24%	$165,000–$315,000
33%	$237,950–$424,950	32%	$315,000–$400,000
35%	$424,950–$480,050	35%	$400,000–$600,000
39.6%	$480,050 and up	37%	$600,000 and up

Kicking the Can Down the Road on Federal Debt Payments

The 2017 Tax Act created a likely growing deficit in Federal budgets by reducing taxes collected. Deficits grow the national debt. The nation needs to pay interest on that growing debt every year, which in turn can grow the deficit. The primary ways out of this vicious cycle are to raise taxes, cut government spending, or both. As a result, tax rates in the future are likely to climb.

Here is what the Congressional Budget Office projected regarding yearly debt before the pandemic:

Government Stimulus

More recently, stimulus checks, grants, and forgivable loans have been provided by the federal government in order to support our economy during the lockdowns across our country. These are massive spending programs that will further increase our national debt. That spike around 2009-2013 in the chart above will be exceeded by today’s events. Again, these will likely lead to tax increases for years to come.

The SECURE Act – Delayed and Accelerated RMDs

Somewhat in response to the 2017 Tax Act, the SECURE Act was passed in late 2019 with two provisions key to this review.

First, Required Minimum Distributions (RMDs) for Traditional 401ks and IRAs now start the year you turn 72, up from 70 and 1/2. As before, you have to take an RMD (and pay tax on it) before you can do a Roth conversion. The delay to age 72 can provide more time for Roth conversions before you have to start taking your RMDs since doing both in a given year can push you into a higher tax bracket.

Second, all funds from inherited IRAs must be distributed within 10 years after you inherit, not over your lifetime as before. This accelerated window could force you to take large distributions sooner than later, pushing you into a higher tax bracket when combined with work or other income, including RMDs from your own IRAs.

The CARES Act – Waived RMDs

Lockdowns and the big drop in oil futures have whipsawed the stock market, recently. Recognizing the need for greater individual financial flexibility, Congress waived the RMD requirements for 2020 in the CARES Act in March. This means you can do a Roth Conversion this year without having to account for an RMD as well. This allows you (or your parents) to convert some funds while you (they) are still in a lower tax bracket.

This can be especially helpful when you take into consideration the new inherited IRA distribution plan from the SECURE Act. Converting funds prior to inheritance can reduce the size of your heirs’ future tax liability.

Unemployment and Rental Income Disruption

Of course, if you lost a job recently due to lockdown effects, you probably won’t be able to make up that income this year. Some of you may have less income from real estate rentals, too. Any diminished income can create headroom in your reported income for a Roth Conversion while still keeping your tax bracket low.

Another consideration is converting a Traditional 401k to a Roth 401k. Not all companies allow this. If you are between jobs, you can convert your Traditional 401k to a Traditional IRA and then convert that IRA to a Roth IRA over time.

Medical Expenses

Some of us are bound to have increased medical expenses this year. If you (or your parents’) expenses are high enough to qualify for a medical deduction on your taxes, that will create additional headroom for Roth Conversion. Just note that the conversion will count as income, so the bar for qualifying for the deduction will get higher as you convert more funds.

Adding it All Up

Most wage earners I know plan to be in a lower tax bracket in retirement, so it is probably better for them to sit this opportunity out unless they strongly believe tax rates will go up.

The sweet spot here is probably for folks who are:

1. No longer earning wages
2. Plan to stay in the same state
3. Not yet taking RMDs (i.e. they are younger than 72).

In this case, as pointed out by Reader Jeanne in a comment on the prior article, your IRA has probably lost value this year, meaning you can convert a higher percentage of your savings for the same tax rate. Then that higher percentage can grow tax-free during the recovery in the years to come.

Similarly, since RMDs are waived this year, folks over 72 can benefit by converting funds this year and possibly staying in a lower tax bracket in future years by reducing their future RMDs. Meanwhile, they enjoy tax-free growth of the converted funds.

Finally, regardless of age, if you have a large Traditional IRA, you can possibly reduce the taxes paid by your beneficiaries by converting funds before you pass. This approach can leave less money in traditional IRAs and thus reduce the amount of money subject to that 10-year distribution. After all, you want to pass on as much wealth as you can to them, right?

Paying the Taxes

Finally, most of the tax advice I have read on the net says you should only do a conversion if you can pay the additional tax out of cash you already have. Meaning, don’t take additional funds out of your IRA to pay the tax, because those funds are taxable too.

How does this sound to you?