Are you looking for a way to make a positive financial move during the bleakest financial time in almost a century? I strongly believe that now is a perfect opportunity to do a Roth IRA conversion. The stars are aligning to make this year the most cost effective time to do a Roth IRA conversion in our lifetimes. A Roth IRA conversion is an excellent long term strategy for reducing your (and your heirs) lifetime total tax liabilities. If you have not looking into the benefits of a Roth IRA conversion, now is the time!
What is a Roth IRA Conversion?
For me to understand these accounts better I view retirement accounts as folders and each folder has different tax treatment. With a Roth IRA conversion all you are doing is taking your investments from one folder and putting them into a different folder that has a different set of tax treatments.
With a traditional IRA you contribute money and get a tax deduction in the year you contribute the money. The money grows tax free and when you withdrawal the money in retirement you pay ordinary income tax on it.
With a Roth IRA you contribute money and do NOT get a tax deduction in the year you contribute. Like a traditional IRA the money continues to grow tax free, however when you withdrawal the money in retirement you do not pay any taxes on it.
A Roth IRA conversion is the process of moving your investments from a traditional account that you already received a tax break on to a Roth account so that in the future you will not have to pay taxes on the withdrawals. Since you already received a tax break, a Roth IRA conversion is a taxable event and you will have to pay ordinary income tax on the amount converted in the current year. You pay the taxes now to not have to pay taxes on the much larger amount that will be withdrawn down the road.
Hopefully this was a good enough explanation of the difference between the accounts and the mechanics of what a Roth IRA conversion is.
Why Do A Roth IRA Conversion Now?
There are several reasons that now is the best time to do a Roth IRA conversion.
The SECURE Act Destroys The Value For Generational Wealth Building:
For starters, the SECURE act passed by congress last year fundamentally changes the way that traditional IRAs work. Historically upon your death you could select anyone in the world to be your beneficiary and that person could keep that IRA forever and take RMDs (required minimum distributions) based on their age, throughout their lifetime. The secure act gutted this major estate planning benefit and now requires the beneficiary to withdrawal all of the money within 10 years. I know this may not sound like a big deal, but let’s lay an example out to show how big of a tax grab this really is.
Let’s say I die at 80 and give a $1 million IRA to my 5 year old great grandchild.
Under the old plan my great grandchild would only have to withdrawal a very small portion of the proceeds each year based on his life expectancy. Historically this would have been well under 1% or $10,000 per year. With only needing to take out $10,000 per year he would have very little tax liability while the portfolio continued to grow at 8% to 10% per year. Under this tax policy by his 18th birthday he would probably have paid less than $30,000 in total income taxes and his account value would have grown to be worth over $4 million. This is a major reason why Roth IRA’s are better for generational wealth building.
Under the Secure Act he would have to take out closer to 12% of the initial balance each year to ensure he depleted the account within 10 years and to attempt to balance yearly withdrawals. This means he would have realized income of over $120,000 each year for 10 years. This income would of course be subject to federal and state income tax and since he has no job he can’t essentially transfer the money to his own account by maxing a 401K, IRA, or HSA to lower his tax bill. He would be paying around $30,000 a year in income tax for 10 years.
This is why moving money to a ROTH IRA is a better deal. The money is already tax free and just gets transferred to the heir. No taxes or RMDs exist. The beneficiary still has to withdrawal all of the funds within 10 years, but no taxes will be owed. Because of this the best strategy is for the beneficiary to leave the money in the account for 10 years to allow growth to continue tax free, then withdrawal all of the money at once, paying no taxes. An additional 10 years should more than double the account value, and once again no taxes are owed. The money should then be put into a UGMA account if the beneficiary is still a minor.
Temporarily Reduced Portfolio Values:
The second reason to do a conversion this year is because the stock market is down significantly. You can keep the assets invested when you transfer them over, so if you own 1,000 shares of the Vanguard Total Stock Market Index Fund you are still converting 1,000 shares whether the price is $50 a share or $100 a share. You are taxed on the current value of the shares on the day of the conversion. Converting while the market is low greatly reduces your tax bill.
For example, with major indexes down 33%, and you started with a $50,000 IRA, it is now likely worth around $33,000. With a conversion the amount converted is recorded as income and hits the top of your tax bracket. Paying taxes on $33,000 in the 22% tax bracket costs $7,260 as opposed to the $11,000 cost of paying taxes on a $50,000 conversion. That’s roughly a $4,000 savings just by doing a conversion now instead of back at the end of 2019.
Reduced Income For 2020:
The third reason to do a conversion this year is because your wages may be down significantly, I know mine are. Because of this you may fall into a lower tax bracket. If you can fill up the 12% tax bracket with your conversion then instead of a $33,000 conversion costing $7,260 in the 22% bracket it will cost only $3,960. So with both the reduction in account value and a reduction in taxable income, the total tax due on converting the same amount of shares could fall by 64%!
Time for some more math: Paying $3,960 NOW to convert $33,000 means $4,000 less in an investment account. (You pay the taxes out of your money outside of the account, so rather than making a $4,000 contribution, you are using the $4,000 to pay the taxes on this Roth IRA conversion) Looking at 8% growth over the next 30 years $33,000 will grow to $360,000. $37,000 would grow to $404,000. Now would you rather in 30 years have $360,000 tax free or $404,000 that you have to pay taxes on?
Future Tax Rates Will Be Higher:
The fourth reason to do a Roth IRA conversion this year is that tax rates absolutely 100% will increase in the future. In 2019 we ran a deficit of almost $1 trillion, and that was with record low unemployment, a runaway stock market, an 11 year bull run, and the largest economic expansion since the end of World War 2. This year we had a $2 trillion extra deficit spending bill for COVID-19 and it looks like there will be another similar bill. This money has to be paid at some point and since taxes are currently at historic lows, the most likely scenario is massive increases in tax rates. I would not be shocked if 20 years from now each tax bracket is 10% higher than it currently is.
Who Should Not Do A Roth IRA Conversion:
If you are in a high tax bracket and in a high tax state. For example, someone in a high tax bracket in California could have a 50% tax bill for doing a Roth IRA conversion. Paying 50% on taxes now, even with the long term benefits of being in a Roth is likely not worth it. In retirement most people will be in a lower tax bracket and may move to a lower taxed state as well.
If you have a limited amount of retirement savings: Ultimately you want to be able to fill up to 0% tax bracket in retirement with tax deferred traditional plans. You get a 12% to 33% tax break when you contribute and you never pay taxes. This would be true for the first $24,800 of withdrawals for a couple with the current tax code. This would be the equivalent of a 5% withdrawal with a balance of $496,000 in retirement accounts. If you are on track to have greater than $500,000 in retirement accounts at retirement then it makes sense to look into doing a Roth conversion AND continuing to contribute to Roth accounts instead of traditional accounts for future contributions. For us, since we plan on filling up our first brackets with rental income, this does not apply and our goal is to eventually get all of our money out of traditional accounts.
People With Obamacare Exchange plans and income would go over 400% of FPL:
Since doing a Roth IRA conversion puts the entire conversion amount on your income for the year this can negatively affect your ACA plan costs. If you estimated your income for the year lower than what it ends up being you are expected to pay back the difference in health care subsidy you received to the federal government. If your total income is below 400% of the Federal Poverty Level, then this repayment amount is limited. The key spots for the limit are 200%, 300%, and 400% of the FPL, so you want to be be under any of these spots with the total expense of your Roth IRA Conversion. Additionally 400% is the fiscal cliff for where Obamacare subsidies completely disappear. Going over 400% of FPL can cost you several hundred dollars per month.
People Who Plan To Use The Money In Under 5 Years: There is a limit on Roth Conversions that the money can not be withdrawn for the first 5 years after the conversion.
What My Roth IRA Conversion Strategy Actions Are:
My income for the year looks at the moment like it will be around $78,000. I have around $60,000 in traditional IRAs right now. I want to eventually move all of this money into Roth accounts.
First I Want To Look At The Tax Brackets.
These are the tax brackets with the $24,800 married standard deduction added to them.
- $0 to $24,800 is 0%
- $24,801 to $44,500 is 10%
- $44,501 to $105,050 is 12%.
- $105,051 to $195,850 is 22%
I want to avoid paying 22% federal income tax, so the maximum income I want is $105,000.
$105,000 – $78,000 in income = $27,000. From a federal income tax standpoint I only want to convert $27,000 this year.
Now I Need To Look At Our Obamacare Healthcare Exchange Situation.
For tax year 2020 they use the 2019 FPL Levels. For a household of 6 to FPL is $34,590. I want to stay just under an even 100%. Since for tax purposes I want to be under $105,000 it makes sense for me to shoot for under 300% of FPL. 300% of FPL is $103,770. If my income is over this amount the limit on repayment moves up from $1,600 to $2,650, effectively adding $1,050 in total tax. Because of this I want to keep my income below this amount.
$103,770 – $78,000 = $25,770. This is the most I should do a conversion on to avoid paying an extra Obamacare penalty.
At this level, converting $25,770 from my traditional accounts to my Roth accounts will cost 12% federal income tax and 4.25% state income tax, for a total tax bill of $4,187. 16.25% of the total conversion.
Doing The Roth IRA Conversion On The Whole Amount:
IF I were to convert everything, the amount over $27,000 would be taxed at 22% AND I would have to pay $1,050 more for the Obamacare over payment. That addition $33,000 would then cost me:
- $1,230 at 16.25 Federal State combined, a total of $200
- $31,770 at 26.25% Federal and State combined a total of $8,339
- AND $1,050 in Obamacare over payment fees.
- Total cost: $9,589 or 29%.
Rather than biting the bullet and doing this all at once I will go ahead and do a Roth IRA conversion on $27,000 of value and leave the rest for future years. There is a good chance that the economic recovery from COVID 19 won’t happen until sometime in 2021, so I may spring for doing another conversion early in 2021 to get the lions share transferred out, assuming that my income in 2021 will be similar to 2020.
I’m 33 years old now and ideally I will live at least another 50 years. Add on the 10 year Roth IRA withdrawal time table and that gives my account 60 years to grow, tax free. Not as good as before the SECURE act, but this is still a major benefit. Doing a Roth IRA conversion even on a modest amount today will save hundreds of thousands of dollars over the coming decades. I can’t think of any better way to spend $4,000 this year. Because the Roth IRA has so many long term advantages it is important to get your children started on their own Roth IRAs as soon as possible so they never have to do a Roth IRA conversion. The book The Kid’s ROTH IRA Handbook: Securing Tax-Free Wealth From a Child’s First Paycheck is an excellent guide to getting started.
What do you think about Roth IRA conversions? Will you be doing one this year?