Roth IRAs have some very important benefits. Assets in a Roth IRA grow tax-free, and any withdrawals are also tax-free. They are not subject to required minimum distributions during your lifetime. They can also be passed down to heirs tax-free. Together, these features make Roth IRAs a powerful long-term wealth building tool.
The trick with Roth IRAs is getting assets into them. There are two ways: by making annual contributions or by doing a Roth conversion.
Annual contributions to a Roth are subject to several limits. For one, you must have earned income to contribute. Then, there is an income limit ($124,000 taxable income for a single filer*) and a contribution maximum (For 2020, you can contribute up to $6,000 ($7,000 if you are age 50 or older.)
A Roth conversion is a transfer of assets from a traditional IRA into a Roth IRA. There are no income or contribution limits for Roth conversions. However, any amount that you convert is taxable. So how many IRA assets you should convert to a Roth depends on how many taxes it will cost to do it.
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Here are some reasons to consider a Roth conversion this year
No RMD in 2020
The CARES Act waived the 2020 required minimum distribution (“RMDs”) from IRAs, inherited IRAs, and employer-sponsored plans such as 401(k)’s. With no RMD, your taxable income may be lower than normal. You can take advantage of this by converting some IRA assets into a Roth IRA. The conversion amount is taxable, but you have full flexibility in choosing how much to convert.
Tax rates are low
Federal tax rates on income and capital gains are historically low. In particular, the 12% and 22% federal income tax brackets established by the Tax Cuts and Jobs Act of 2017 are substantially lower than the 15% and 25% tax brackets under the previous law. However, these low tax rates may not last long. They are scheduled to sunset in 2025, and Congress could change them even before then. By converting some of your IRA assets this year, the taxes you will pay will be at today’s rates. What’s more, once assets are in a Roth, you won’t have to take any required distributions at potentially higher tax rates going forward.
Reduce taxes for your heirs
The Secure Act shortened the time most non-spouse beneficiaries** have before they are required to distribute an IRA. Beneficiaries such as children and grandchildren must now distribute all (and pay taxes on all) of an inherited IRA within 10 years. Inherited Roth IRAs will also be subject to the 10-year distribution requirement. However, those distributions will be tax-free. So, converting IRA assets to a Roth can help reduce the future tax impact of your inheritance for loved ones.
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Deciding how much to convert
As we mentioned earlier, the amount you should convert to a Roth depends on how much taxes it will cost. Since any amount you convert is added to your taxable income, it will increase your tax bill and could bump up your tax bracket. To stay within the same tax bracket, you would convert no more than the difference between your current tax bracket’s top income amount and your pre-conversion taxable income.
Here is an example for a married couple with a standard deduction who want to stay within the 12% tax bracket:
2019 taxable income sources:
| Taxable Social Security | $30,000 |
| Required Minimum Distribution | $70,000 |
| Standard Deduction | -$24,000 |
| Total Taxable Income | $76,000 |
2020 taxable income sources with Roth conversion:
| Taxable Social Security | $30,000 |
| Required Minimum Distribution (None for 2020) | $0 |
| Roth IRA Conversion | $74,250 |
| Standard Deduction | -$24,000 |
| Total Taxable Income | $80,250 |
The conversion amount keeps the couple’s taxable income in the 12% tax bracket, while allowing them to move a sizable chunk of their IRA assets into a Roth IRA, where all future growth and distributions are no longer taxable.
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Summing It Up
Roth IRAs are among the most tax-favored assets you can own, so a strategy to get assets into them can be beneficial. However, converting too much can cause a big tax bill, so determining how much and when you should convert is critical. It’s one example of the long-term tax planning we help our retiree clients do in order to grow and protect their wealth. Contact us today to discuss how we can help you develop a multi-year plan that aligns with your goals.
*Those filing single, head of household or married filing separately with income between $124,000 and $139,000 can contribute a reduced amount. Those married filing jointly with income below $196,000, can make the maximum contribution. Those married filing jointly with income between $196,000 and $206,000 can contribute a reduced amount.
**There are exceptions to this rule for those with disability or chronic illness, those not more than 10 years younger than the decedents and minor children of decedents. Different distribution options are available for each of these groups.
