The Roth conversion has been a tool available to financial professionals for a long time to help clients minimize future tax liability. Conversions are helpful in specific instances, but many times are not applicable to every client situation. What about the culmination of events in 2020 has made the Roth conversion more relevant than years past?
What is a Roth Conversion?
Most employees will contribute to a tax-deferred retirement plan while they are working. This comes in many forms: a traditional IRA, a 401(k), a 403(b), etc. These retirement plans provide you with a tax deduction in the year a contribution is made. The funds then grow tax-deferred until it becomes time to make withdrawals. The IRS requires these account types to withdraw a Required Minimum Distribution at age 72 (changed in 2020 from 70 ½). This means you will pay taxes on the original contributions and the investment growth that has accrued over the years.
A Roth conversion is the transferring of retirement funds from a tax-deferred IRA account into a Roth IRA. Roth IRAs differ from the previous listed account types because taxes are paid in the year in that the contribution or conversion takes place. On top of that, the growth on the contributions/conversions is exempt from taxes and there are no mandatory withdrawals during retirement.
What is the purpose of a Roth Conversion?
There are a few reasons why Roth conversions are a popular financial planning tool. One of the most common reasonings for converting tax-deferred funds to a Roth is to create a tax-free bucket for withdrawals during retirement. Having both tax-deferred and tax-free assets during retirement provides more flexibility when it comes to tax planning and client portfolio distributions for spending. Roth conversions can also be appealing if you expect to be in a higher marginal tax bracket in retirement than the year you make the conversion. This is rare, but plausible especially in unique circumstances like this year. By strategizing, you may be able to use this tool to make a series of smaller conversions during years with lower tax implications to minimize taxes paid over the long run.
If you have time on your side, compounding returns on the conversions could benefit you over a long period of investing. On traditional IRA assets, investors pay taxes on investment gains when they withdraw money but with Roth assets, the gains grow tax-free. It is also a tool for investors who would like to leave tax-free assets to their heirs. If that is the case, a Roth conversion may make sense for your situation.
Why is this a relevant topic in 2020?
This year has been filled with trials and tribulations and we still have half a year ahead of us. From a global pandemic to world-wide protests and heightened discussions regarding race discrimination, the world has seen a great deal of challenges and change in 6 short months. What about this year makes the conversation regarding Roth conversions more relevant than years past? First off, many Americans are going to see less income this year in comparison to prior years. This could be due to losing a job or seeing less customers during the government stay-in-place order. This could also be due to The Cares Act allowing those who are required to take Required Minimum Distributions to skip it for the year 2020, creating less taxable income this year. We are also living during a time of historically low-income tax brackets. With the increase in government spending, unemployment benefits and use of federal resources, we will most likely see increased tax rates in our future. If that is the case, it may make sense to pay taxes this year before they are raised.
Our team at Sharkey, Howes & Javer is here to help you explore all your financial options. Contact Sharkey, Howes & Javer today to speak with a CERTIFIED FINANCIAL PLANNER™ to see if a Roth conversion makes sense for you in 2020.
