In the realm of personal financial planning, the U.S. Government has served up some curiosities in the last 12-months, and my guess is more are around the corner.
This blog will touch on some recent changes in tax laws due to COVID that has reinvigorated a nuanced planning tactic that’s been around for a while. If you have a traditional IRA, if 2020 was a low-income year for you, if you are in retirement, if you want to give your children some tax free income after your demise, then this might be something to consider.
By no means is anything that follows tax advice, nor should it be construed as a recommendation. The following is a starting point for considering a technique known as a Roth IRA conversion. It is a specific, case by case, exercise and takes more analysis than following the simple points below.
It all began with the SECURE Act which passed in late 2019. We wrote about it here. A key feature in the SECURE Act was the semi-death of the stretch IRA. Stretching an IRA meant getting the most of the tax benefits from a traditional IRA.
Ideally, you would be able to build up a big balance in your IRA or retirement account, take your required distributions starting at age 70 1/2, and leave a legacy for your beneficiary. The beneficiary would inherit the IRA and begin taking required distributions over their lifetime. The younger they were the smaller the annual distribution. This helps defer taxes into the future and “stretch” the IRA for a long, long-time.
The SECURE Act, shifted the RMD age to 72, and also changed the rules around what happens after you die. If a non-spouse inherits the IRA or retirement account, it now must be completely withdrawn in 10 years. The stretch went from an indeterminate, but very long expected withdrawal period, to a short 10 years. Please note that if the IRA beneficiary is a spouse, or one of four other categories, these rules do not apply. So for purposes of this blog, we will just concentrate on the inheritance of a traditional IRA by the children from the last-to-die parent.
The wrinkle is that children will inherit an IRA during their peak earning years, when their ages are between 50 and 70. Take for instance a 50-year-old physician making $400,000 per year who just inherited an IRA worth $2,000,000 from her mother. Previously, she would have taken RMDs based on her life expectancy based on a single life table. The year one RMD would have been $58,479. Yet under the SECURE Act, the entire IRA needs to be withdrawn by the tenth year. Levelized withdrawals mean adding $200,000 per year to income. And, withdrawals are all incremental income taxed at ordinary rates. Suddenly, she has income of $600,000 which is subject to all the supplemental taxes and surcharges that the US government has been levying on high income earners over the last few years.
Then along comes Covid-19, economic calamity, and Congress passing the relief bill known as the CARES Act. A key tenet to the CARES Act was the suspension of required minimum distributions in 2020. We wrote about the bill here . The stimulus, not to mention the potential results from the 2020 Presidential Election, has many thinking taxes are bound to go up in the future, meaning 2020 may be an interesting year for Roth IRA Conversions.
A Roth IRA conversion simply trades a tax payment today for no tax payment tomorrow. An traditional IRA grows tax-deferred, meaning you deposit pre-tax dollars, they grow tax-free but you pay taxes when withdrawals are made. A Roth IRA grows tax free meaning you deposit after-tax dollars; they grow tax-free and no taxes are paid at withdrawal. Once money is in a Roth IRA no more taxes are owed as long as certain provisions are met.
In a Roth Conversion you pay taxes today to avoid paying taxes tomorrow.
Withdrawals are not taxed if:
- You are over the age of 59 ½ or after death or disability, AND
- You have waited 5 years since January 1st of the year of the first contribution.
To put it in perspective of our physician example, if that physician had inherited a ROTH IRA instead of a traditional IRA, she would still need to take distributions culminating in a zero balance in year 10, but she would not owe any taxes on the distributions.
The partial death of the stretch and an RMD holiday because of Covid-19 in 2020 means opportunity for full and/or partial conversions this year. First, a caveat. Roth conversions are not a slam dunk and they should not be done by everyone. It is not a one size fits all and each individual situation should be analyzed with specifics.
So, just to be clear Roth conversions are not a panacea. They are only right in the right circumstances.
Some of the reasons to convert may be:
- Taxpayers have favorable tax attributes such as net operating losses, tax credits, no income or large charitable contributions, and/or
- The required minimum distribution was suspended, and/or
- The taxpayer can pay taxes from the conversion with non-IRA funds, and/or
- The taxpayer is in a more favorable tax brackets than the beneficiary, and/or
- The taxpayer wants post-death distributions to be tax free, and/or
- The taxpayer expects higher future taxes.
Let’s say you do meet some of the reasons to convert. The next step is analysis. For illustrative purposes we can compare the after-tax terminal value between an IRA and a Roth IRA. This is a simplified version of what would actually happen. Rather than compare over-time withdrawal schedules, we’ll compare point-in-time estimates net of tax.
We’ll take a look at two examples, where our illustration assumes $1 is invested into a certain account type, and liquidated at the end of the period.
First, highlighted in yellow, indicates a 35% tax rate today and in the future. Over 25 years at 7% the IRA grows to $3.88 after-tax and the Roth IRA grows to $3.53 after-tax. Under these circumstances the IRA would be ahead of the Roth by 10%.
Second, highlighted in green, indicates a 25% tax rate today and 37% in the future. Again, over 25 years at 7% the IRA grows to $3.79 and the Roth IRA grows to $4.07. In this case, the Roth IRA is ahead by 7%.
As the two illustrations show, conversions can be good for those in a low tax bracket today but expect to be in a higher tax bracket in the future.
With required minimum distributions suspended for 2020 and many experiencing lower incomes due to Covid-19 induced economic weakness as well as the partial death of the stretch IRA, 2020 may be a great year to make a partial conversion, if, of course, you can afford it. Worth a thought!
At Wright Associates, we are trying to make sense of the confusing. We’re are trying to be opportunistic when the U.S. government gives us changing legislation. Call us for more information.