While an economic downturn is never good news for investors, it presents a potentially valuable opportunity for individuals considering converting their traditional IRA (and funds that have been rolled over from a qualified plan) to a Roth IRA.
It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from the date of conversion on, which can result in a significant tax advantage.
Why a Roth IRA?
Roth IRAs have two major advantages over traditional IRAs:
- Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the account holder reaches age 59-1/2, or on account of death, disability, or the qualified purchase of a first home.
- Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs (as well as individual qualified plans). Therefore, a Roth IRA account holder who reaches age 72 does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on to heirs.
Why a Roth IRA conversion now?
Several reasons make this a good time to consider making this move:
- The stock market has taken a major hit due to the COVID-19 crisis. Presumably your IRA account balance may be at a low point which would limit the amount of taxable income to be reported on a conversion event.
- Low individual income tax rates make this a favorable time to pick up additional income. Most individuals expect tax rates to increase in the near future to help pay for the COVID-19 aid that was disbursed.
- The expectation of a low income year – whether due to layoffs, lower business profits, or the lack of required minimum distributions from an IRA – presents a more conducive environment for reporting the additional income resulting from a Roth conversion.
Who should consider a Roth IRA conversion?
An IRA-to-Roth IRA conversion should be considered by individuals who:
- Can afford the tax on the converted amounts;
- Anticipate being in a higher tax bracket in the future than they are currently in; and
- Have a significant amount of time before reaching retirement or needing to access these funds to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax.
There are many tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth. If you wonder whether converting now would be a good option for you, please reach out to your DunlapSLK team member.