Is Now the Right Time to Convert to a Roth IRA?

By Galina Portnoy  |  May 14, 2020

Is Now the Right Time to Convert to a Roth IRA?

The COVID-19 pandemic has brought with it many challenges, including the current downturn in the stock market. Nevertheless, there are smart financial and tax planning strategies that can be put in place during these challenging times. For example, if you’ve thought about converting your traditional Individual Retirement Account (IRA) into a Roth IRA, now may be the time. The stock market decline, coupled with today’s low tax rates, actually creates favorable conditions for a Roth conversion. Therefore, if conversion is something you have been considering, now may be the best possible time to act.

Why Consider a Roth Conversion

Both traditional and Roth IRAs are designed to build a nest egg for retirement, and both provide tax breaks. The main difference between a traditional IRA and a Roth IRA is when you will receive the tax break. If you contributed to a traditional IRA, and reduced your taxable income by the amount of your contribution in the year the contribution was made, you did not pay tax on that amount. Therefore, at the time of withdrawal, you will be taxed at the ordinary tax rate on the distribution amount. In a Roth IRA, the opposite occurs. The contributions are made with after-tax money and no tax deduction is taken on the contributed amount. As a result, withdrawals are tax-free for life once the account holder reaches age 59 ½ and satisfies the five-year holding period, which begins on the first day of the first year in which Roth IRA contributions were made. Once the five-year period has expired, the account holder can withdraw funds from the Roth IRA tax-free even before reaching age 59 ½. In this situation, however, the penalty and tax-free amount is limited to the amount of the contribution made to the Roth IRA. Any withdrawal that exceeds the amount of contribution would be deemed from earnings and would be subject to tax and a 10% early withdrawal penalty unless the withdrawal falls under certain exceptions. The converted amount is treated the same as a regular Roth IRA contribution once the five-year period rule is met. It is important to remember that each conversion has its own five-year holding period.

The biggest advantage of the Roth IRA is that you do not need to take Required Minimum Distributions (RMDs) at any age or during your lifetime. If you do not get to use the funds in your Roth IRA, your beneficiary would need to follow special rules to make sure that their distributions are not taxable as well. These rules are different for spousal and non-spousal beneficiaries. A surviving spouse can transfer the funds into his or her own Roth IRA account, which allows the surviving spouse to treat that IRA as his or her own. A non-spousal beneficiary would have to follow the new 10-year rule created by the Secure Act unless the beneficiary qualifies for certain exemptions. The 10-year rule provides that the inherited IRA account must be emptied within 10 years from the date of the IRA owner’s death. This rule applies to beneficiaries of both traditional and Roth IRAs. Since distributions from traditional IRAs are taxable and there is no longer an option to stretch distributions over the beneficiary’s life, accelerated taxable income may result in a hefty tax bill for the beneficiary. Inherited Roth IRAs, on the other hand, may be a great gift since a beneficiary will generally not owe tax on any withdrawals over that 10-year period.

Many Americans contribute to pre-tax retirement accounts (including traditional IRAs) in order to defer tax on contributed amounts, and with the hope that their tax bracket at the time of retirement will be lower. But this does not come to fruition for everyone, particularly in the case of individuals who have saved a significant amount of money. In reality, many people enter retirement in the same tax bracket—or, in many instances, an even higher tax bracket—when they combine their investment income, Social Security, pension and RMDs.

Why Is Now the Right Time?

When you convert your traditional IRA to a Roth IRA, the fair market value of converted assets at the time of the conversion will be added to the income for the year it was converted and will be included in the tax calculation for the same year. As a result of the COVID-19 pandemic, markets are down and the majority of portfolios have dropped in value. Therefore, this added taxable income from conversion most likely will be less than it would otherwise be at a time of strong markets.

Another major factor in a Roth IRA conversion is tax rates. Today’s low tax rates (thanks to tax reform and the Tax Cuts & Jobs Act) are set to expire in 2025. (This was set up before the COVID-19 pandemic hit and before federal government expenditures took place to fight it. So the future tax rate increase is imminent.) By converting now, you take advantage of paying a lower tax rate on the amount you convert to a Roth IRA.

You reap another big advantage down the road: the converted funds continue to have tax-free earnings and will grow in value tax-free when markets rebound, with no tax on capital gains realized if securities are sold and no tax to pay when distributions are taken.

The CARES Act presented an additional advantage for the conversion. The general rule for conversion is, if an individual is required to take RMDs, the conversion can be done only after the RMD is taken for the year of conversion. Since the 2020 RMD is suspended, a taxpayer may convert additional funds that otherwise would be taxable anyway if RMDs were to take place.

Additional Considerations

Conversion is not for everyone and many factors should weigh into your decision. If you are considering a Roth IRA conversion, bear in mind that taxable income will be increased by this conversion and it can push you into a higher tax bracket. The conversion could also increase the amount of taxable Social Security benefits and the amount of Medicare premiums, as well as the threshold for medical deductions if you itemize. It could also trigger phase-outs of certain credits. In addition, if you have a child in college, it could potentially reduce your child’s financial aid eligibility for the year of conversion.

Before you decide to convert to a Roth IRA, determine: (i) whether you expect your income to be about the same or lower/greater in the future; (ii) whether you have enough funds to cover your tax bill with increased income in case of conversion; and (iii) whether you need your money in the next five years and whether you have other funds to be used for living at the time of retirement. In addition, remember that you are no longer permitted to undo or “recharacterize” a Roth IRA conversion. Consult with your tax advisor or Marks Paneth relationship partner for more information on whether converting to a Roth IRA is the right choice for you.

About Galina Portnoy

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Galina Portnoy, CPA, is a Director in the Private Client Services Group at Marks Paneth LLP.  For more than 20 years, Ms. Portnoy has provided tax, accounting and consulting services to high-net-worth individuals, family partnerships and their related entities. She has advised on a broad range of complex issues, including strategic income tax planning and execution, gifts and estates, philanthropy, matrimonial accounting, business management and planning, real estate and other transactions, multi-state taxation and financial... READ MORE +

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