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George F. Bearup, J.D. Senior Legal Trust Advisor

11-Jun-20

Roth Conversions in a CARES Act World

Take-Away: There may be several good reasons for IRA owners to seriously consider a Roth conversion in 2020. Each owner’s circumstances are unique, so this is not a ‘one-size-fits-all’ decision, but the possibility of a Roth IRA conversion, in whole or in part, warrants a discussion with IRA owners at this time.

Why A Roth IRA Conversion Makes Sense: Several of the reasons to consider a Roth IRA conversion in 2020 follow:

  • Suspended RMDs: The CARES Act waived required minimum distributions (RMDs) for 2020. The waiver extends to an IRA owner over age 70 taking RMDs and also to those beneficiaries who inherited IRAs. That means that for 2020 there will be less ordinary income to report, which might possibly keep the IRA owner (or beneficiary) in a lower marginal federal income tax bracket. The lower the income tax paid, the more cost-efficient the Roth IRA conversion becomes.
  • Suspended 10% Excise Tax: The CARES Act suspended for 2020 the 10% excise tax for early distributions from an IRA. The suspension of that penalty reduces the tax burden when funds are distributed from an IRA for a Roth conversion by someone under the age 59 ½.
  • Furloughs and Lay-offs: An IRA owner may have been furloughed or laid-off. While they may have received some unemployment compensation, that compensation may not have completely off-set the loss of their earnings. Again, this may cause the IRA owner to have less reported income for 2020, in turn keeping them in a more favorable marginal federal income tax bracket with a Roth conversion when the converted IRA income must be reported.
  • Market Volatility: This would have been a far more persuasive reason back in March than it is in June with the ‘bounce back’ in the markets. However, we are cautioned that the market could plummet again if there is a new wave of COVID-19 victims with the states now reopening. If the market drops again, that means that there is a smaller amount of ordinary income recognized on the conversion of a traditional IRA to a Roth IRA. The smaller amount of taxable income recognized, the smaller the amount of the income tax ‘pain’ incurred when making the conversion to a Roth IRA.
  • Historically Low Tax Brackets and Rates: The 2017 Tax Act brought historically wider income brackets and historically lower income tax rates. The 22% bracket for a married couple is up to $171,050. The very next bracket, at the 24% tax rate, ranges from $171,051 to $326,600. The next tax bracket, at 32%, starts at $326,601. A lot of income can be absorbed with a Roth IRA conversion at these relatively low tax rates. The widened tax brackets and favorable income tax rates are set to sunset after 2025. If the complexion of Congress changes after the 2020 elections, all bets are off how long these income tax brackets and rates will remain available to be exploited with a Roth conversion.
  • Public Debt: The federal government just went another $2+ trillion into debt with the CARES Act in March. At some point, perhaps in the near future, Congress will actually do something about the ‘Debt that Ate America’ by increasing income taxes. Best to own a Roth IRA which provides tax-free income as opposed to a traditional IRA which is subject to RMDs and forces the owner to recognize ordinary income when that national day of reckoning finally arrives (or deal with a 50% penalty for not taking an RMD.)
  • Mitigate Future RMDs: For those traditional IRA owners who have very large balances, they must understand that someday (soon?) they will be forced into taking large RMDs, all of which will be taxable income. Roth IRAs generate tax-free income.
  • Protect Surviving Spouses: The current income tax brackets and rates are ‘stacked against’ a surviving spouse when the survivor files as a single taxpayer. Most surviving spouses take an IRA rollover. That rollover will ultimately attract an income tax when the survivor’s age 72 arrives. For example, a married couple will be under the 32% marginal income tax bracket with income over $326,600. The surviving spouse, who is now single, will reach the 32% marginal income tax bracket with a reported income of only $163,301. If the surviving spouse inherits a Roth IRA, which is not subject to RMDs and produces no taxable income, it is far more likely the survivor will remain in the 22% or 24% marginal income tax brackets.
  • Defuse the SECURE Act: The SECURE Act added the rule that most traditional IRAs that are inherited by non-spouses must be emptied within ten years after the IRA owner’s death. That rule change forces non-spousal  beneficiaries, e.g. children, to take their deceased parent’s IRA over a much shorter period, exposing the distributions to income taxation at possibly at higher marginal tax rates when the taxable RMD is added to the child’s own income. Conversely, inheriting a Roth IRA permits the inherited Roth IRA to grow for 10 years, generating tax-free income, before having to be emptied on the 10th anniversary of their parent’s death.
  • Legacy Planning: The income taxes paid by the IRA owner on a conversion of their traditional IRA to a Roth IRA might be considered an additional  nontaxable gift to the owner’s heirs. The income taxes paid on the Roth conversion will reduce the owner’s gross taxable estate. This could mean more wealth ultimately passing to their heirs if no federal estate tax is owed. If Joe Biden is elected President, he has made it clear that he wants to reduce the federal estate tax applicable exemption from $11+ million to $3.5 million per person. Reducing the size of the IRA owner’s taxable estate through a Roth conversion might help the heirs to avoid paying any federal estate tax.
  • State Income Taxes: As noted, paying the income tax on a Roth IRA conversion reduces the owner’s taxable estate. Assets remaining in a traditional IRA on the owner’s death will be taxed on the full value of the traditional IRA, not reduced by the income tax that will later be paid on the IRA distributions to the beneficiary. There is an income tax deduction for the estate tax paid on this ‘income in respect of a decedent.’ [IRC 691(c).] However this income tax deduction is based only on the federal estate tax paid associated with the traditional Ira, and it does not include an income tax deduction for any state inheritance tax paid. In addition, state income tax paid on the Roth IRA conversion reduces the owner’s taxable estate, but state income tax paid on post-death traditional IRA distributions provides no estate tax benefit.

Who Should Consider a Roth Conversion?: The ideal candidate for a Roth IRA conversion should have as many of these circumstances as possible:

  • The individual can pay the income tax on the Roth IRA conversion out of a taxable investment portfolio.
  • The individual will be in the highest income tax bracket in the future when IRA distributions would be required.
  • The individual will not need to withdraw funds from the Roth IRA during their lifetime.
  • The individual’s estate will be subject to estate taxation at the individual’s death and the death of their spouse.

Who Should Not Do a Roth Conversion?: The following circumstances should deter an individual from engaging in a Roth IRA conversion:

  • The individual expects to be in a lower income tax bracket at their retirement, considering their other sources of income in retirement years.
  • The individual will need to use IRA distributions to take advantage of lower income tax brackets.
  • The individual who wants to preserve the option of using income from their traditional IRA to offset future costs for long-term care or other significant medical expenses.
  • The individual plans to use their traditional IRA for charitable contributions or QCDs.

Reality Check: It is important to remember that the 2017 Tax Act eliminated a Roth re-characterization, or ‘do-over,’ if the market goes down after a Roth IRA conversion, which creates a risk that the anticipated income tax savings with a Roth conversion will not be achieved. As such, that is a risk that always needs to be factored into a decision to make a Roth IRA conversion.

Equally important is my cynical view of Congress. While Roth IRAs have been pitched for several years as providing tax-free income and no RMDs for the Roth IRA owner, and tax-free income to their Roth IRA beneficiaries for the beneficiary’s lifetime, we also know that Congress can just as easily change the tax laws. We saw that occur last December with the SECURE Act when Congress imposed the 10-year maximum distribution rule on inherited Roth IRAs, when before the beneficiary could withdraw tax-free income over their lifetime.

Consequently, while a Roth IRA conversion may make a lot of tax-sense these days, the perceived income tax benefits making the conversion could be short-lived, if Congress actually decides to address the federal deficit with a new tax regime where some or all of Roth IRAs may be subject to taxation.

Conclusion: A partial or serial conversion of a traditional IRA to a Roth IRA may allow an IRA owner to fine tune the amount of their Roth IRA conversion with the passage of time. This year a traditional IRA owner may have a lower income year than is normal. Thus, that individual may want to take advantage of a lower marginal income tax bracket in 2020 to convert a portion of their traditional IRA to a Roth IRA. Add to that the one-year suspension of the 10% excise tax on early distributions from a traditional IRA, and there may be an even greater incentive to make a partial Roth conversion in 2020. If the IRA owner decides to delay taking social security until a later age that fact, too, might warrant a partial or serial conversion of a traditional IRA to a Roth IRA for a period of years before the owner begins to take social security. Each person’s financial situation is different, so there is no easy answer to the question if a Roth IRA conversion should be pursued at this time. About the only thing you can say is that the current environment (low tax income rates, wide income  tax brackets, lower taxable income, no early distribution 10% penalty) will probably not get any better in the years to come.