COVID-19 has altered the landscapes of our daily lives. As most of us stay home, safe and healthy, but traveling, dining out, and socializing less than we would prefer, we’re given an opportunity to consider unexpected consequences and opportunities.
We may not be able to take the vacations we were planning, but we’re able to take our dogs on multiple walks every day, try out time-consuming recipes, and spend quality time with family. Like vacation plans, investment portfolio balances are a casualty of COVID-19. The markets experienced significant volatility in March, 2020 (the S&P 500 was down over 30% from its peak at one point), and although markets have made positive steps toward recovery in April and May, there is still a long road ahead for many sectors. But, like the time at home with our families (and pets), there may be a silver lining in the market volatility caused by COVID-19.
Thanks to COVID-19, now may be the time to convert a portion of your traditional IRA to Roth.
A traditional IRA is funded with pre-tax dollars and a Roth IRA is funded with after-tax dollars. When you’re required to take IRA distributions from a traditional IRA at the age of 72, you’re also required to pay taxes on the funds you distribute. There is no requirement to take funds from your Roth IRA, and if you do choose to take distributions, they are tax-free.
Funds in a traditional IRA can be converted to Roth IRA, which sounds like an obvious choice, who doesn’t want tax free growth and no distribution requirements? It should come as no surprise that there is a catch – you must pay taxes on any funds that you convert. Ordinarily, the benefits of converting from traditional IRA to Roth IRA are often outweighed by the determent of paying taxes on the conversion amount. However, 2020 is no ordinary year.
There are two primary factors that make 2020 an excellent year to consider a Roth IRA conversion:
- No Required Minimum Distributions. Under the CARES Act, there are no required minimum distributions (RMDs) for 2020. RMDs are portions of a traditional IRA that you are required to annually distribute and pay taxes on. Since there are no RMDs this means that you may be in a lower tax bracket for 2020.
- Market volatility. Normally, market volatility is negative for your investments, but not if you are looking to do a Roth conversion. When you convert to Roth you can convert cash or you can convert in-kind, meaning you would move over securities in your traditional IRA to a Roth IRA. Market volatility affords you the opportunity to pay taxes when the value of these securities are discounted and lock in tax-free growth going forward.For example, if you have 10 shares of Company A in your traditional IRA that are worth $10,000 and their value drops to $7,000 due to COVID-19 volatility, and you convert them to Roth, you’ll only have to pay taxes on $7,000 to convert the 10 shares instead of the $10,000 that you would have otherwise had to pay taxes on prior to the volatility.
The lowered tax liability caused by the waiver of RMDs for 2020 and the ability to convert discounted shares creates a favorable environment for Roth conversion. Numbers often speak louder than words.
Consider the following hypothetical:
Bob and June are 73-year-old retirees. Bob has a traditional IRA of $1,000,000. Aside from his required minimum distribution, they have annual taxable income of $60,000 (after applicable deductions and credits) from Social Security and various other income sources. This income is sufficient to meet their spending needs so they choose not to take an RMD (which would be approximately $40,000) for 2020. In his IRA, Bob has 20 shares of Company B stock that had a value of $30,000 prior to the volatility, but currently have a value of $20,000. Bob chooses to make an in-kind Roth conversion of the 20 Company B shares.
Bob and June are usually in the 22% federal tax bracket, but since they do not take an RMD for 2020, they are in the 12% federal tax bracket. They will pay taxes on $20,000 to convert the 20 shares of Company B stock to Roth, but this amount will not move them into the next tax bracket. The 20 shares of Company B stock will now grow tax-free and Bob and June will not be required to take distributions from the Roth IRA during their lifetime.
Compare, in the previous year Bob and June would have had to pay taxes on $30,000 at 22% to convert the 20 shares to Roth, or $6,600. In this scenario, they only need to pay taxes on $20,000 at 12%, or $2,400, to convert the 20 Company B shares to Roth. Bob and June are able to convert the same amount of shares but pay $4,200 less in federal taxes. This hypothetical is simplistic but serves to illustrate the unique set of circumstances 2020 presents.
Overall, 2020 has been a challenging year, but the silver lining of the upheaval in the markets may be the opportunity to convert funds to Roth and lock in tax-free growth for years to come. With that said, everyone’s financial picture is different, and this strategy may not make sense for everyone.
Stay safe, healthy, and sane and best of luck perfecting your sourdough starter/growing a garden/training your puppy/jigsaw puzzle or whatever COVID-19 project you are focusing on until this storm has passed and sunny skies once again return.
If you’d like to speak with a Roehl & Yi financial advisor about your wealth management and investment strategy, please call 888-683-4343.
Written by: SARAH MELLGREN, JD, CFP®, Roehl & Yi