3 Things to Consider for IRA Conversion: Is 2020 a good year to do this?
In addition to other potential tax benefits, Standard IRA accounts shelter investments from tax on each year's income and profit. On the other hand, all the value that is in the IRA will eventually be distributed and taxed as ordinary income or usually the highest rate. For this, and other reason, the question of moving some Standard or Rollover IRA dollars to a Roth IRA comes up fairly often. The Roth structure allows for the same tax deferral of gains and income, but all distributions are fully tax-free. That is a very attractive aspect of the Roth structure. The decision whether to convert a portion or all of the value in a Standard/Rollover IRA needs careful consideration and calculation.
As we know, 2020 is already a year like few others. Because of various odd dynamics, it is a year when looking at Standard to Roth IRA conversion might be worth the consideration. The question of whether an investor should do a conversion is a case by case situation. Is it age? Is it
Does a Roth IRA Conversion make sense?
Three things to consider:
1. How many years before retirement?
2. How much has your portfolio dropped?
3. Where do you plan to live (state) in retirement?
Basically, it's a primarily a question of arbitrage. Is your tax bracket in the future likely to be lower than current and is there reasonable time in front of you to recoup the immediate cost of paying that premium tax today. The more time you have before retirement, the less the bracket reduction is necessary, assuming it grows again back to that previous value and more.
My .02¢; There is no real rule of thumb, b/c there is no guarantee what tax rates will be in the future. If someone is sure they will not be living in CA in retirement it might not make as much sense. Keep in mind that CA has no capital gain rate, so all conversion is taxed at full rates. In the future, if you are considering a state with little to no income and/or capital gain tax and you will be in a lower bracket and form of income, it may not make sense to make full conversion tax in CA and then to retire and not have a state income tax at all in the future.
The reason this year may be an opportunity to convert is because asset values and incomes are down. Hypothetically, say you had 100k in your IRA on 12/31/2019, that was all deducted over the previous years, so net value is greater. The value today after the down market is $85k (whoops, not good) and your income, as a result of CV19, etc. is less than years past and possibly in years to come, the math may work. Also, if you own a business, the PPP loan that was used to replace a portion of your wages along with your employees, it's likely not taxable (neither are expenses deductible), so taxable income for 2020 may be significantly less, which is another reason conversion may work.
The $15k value drop is some arbitrage, assuming it will increase back to $100k in the future. You got the deduction for the value drop of $15k originally on previous tax returns, you will avoid the income tax of that $15k value on conversion and in the future that $15k earned again is tax free, remembering that earning that $15k back is a little tougher, from a base of $85k minus tax due of approx. $3750, so now it is net $81,250. All that said, most of the benefit is not present cash flow (actually cash outflow), so it doesn't always feel great, unless the future bracket is certain to be lower and the real dollar savings is significant. For instance, add a zero the IRA. Now it's $150k difference and more. There is an IRS Roth conversion rule that allows you to spread the tax from the conversion over two years. So using the example above, the $85k conversion above would have a likely Fed tax of approx. $19-24k, which could be paid $10k next year and $10k the following year.
Generally speaking, less than a 5-10 year time before retiring or distributing and the math is too unknown to say for certain. Many simply like the structure of the Roth for both the tax-free distributions, the lack of Required Mandatory Distributions at age 72 and the efficient legacy gifting to beneficiaries.
The Roth is the best structure available, but tough to get significant dollars into it. This is also the same for Roth 401k conversion. If your company offers a "Roth 401k" contribution option in it's Plan, seriously consider it. The Roth 401k doesn't have any income limitations, the Roth IRA does.
As we know, 2020 is already a year like few others. Because of various odd dynamics, it is a year when looking at Standard to Roth IRA conversion might be worth the consideration. The question of whether an investor should do a conversion is a case by case situation. Is it age? Is it
Does a Roth IRA Conversion make sense?
Three things to consider:
1. How many years before retirement?
2. How much has your portfolio dropped?
3. Where do you plan to live (state) in retirement?
Basically, it's a primarily a question of arbitrage. Is your tax bracket in the future likely to be lower than current and is there reasonable time in front of you to recoup the immediate cost of paying that premium tax today. The more time you have before retirement, the less the bracket reduction is necessary, assuming it grows again back to that previous value and more.
My .02¢; There is no real rule of thumb, b/c there is no guarantee what tax rates will be in the future. If someone is sure they will not be living in CA in retirement it might not make as much sense. Keep in mind that CA has no capital gain rate, so all conversion is taxed at full rates. In the future, if you are considering a state with little to no income and/or capital gain tax and you will be in a lower bracket and form of income, it may not make sense to make full conversion tax in CA and then to retire and not have a state income tax at all in the future.
The reason this year may be an opportunity to convert is because asset values and incomes are down. Hypothetically, say you had 100k in your IRA on 12/31/2019, that was all deducted over the previous years, so net value is greater. The value today after the down market is $85k (whoops, not good) and your income, as a result of CV19, etc. is less than years past and possibly in years to come, the math may work. Also, if you own a business, the PPP loan that was used to replace a portion of your wages along with your employees, it's likely not taxable (neither are expenses deductible), so taxable income for 2020 may be significantly less, which is another reason conversion may work.
The $15k value drop is some arbitrage, assuming it will increase back to $100k in the future. You got the deduction for the value drop of $15k originally on previous tax returns, you will avoid the income tax of that $15k value on conversion and in the future that $15k earned again is tax free, remembering that earning that $15k back is a little tougher, from a base of $85k minus tax due of approx. $3750, so now it is net $81,250. All that said, most of the benefit is not present cash flow (actually cash outflow), so it doesn't always feel great, unless the future bracket is certain to be lower and the real dollar savings is significant. For instance, add a zero the IRA. Now it's $150k difference and more. There is an IRS Roth conversion rule that allows you to spread the tax from the conversion over two years. So using the example above, the $85k conversion above would have a likely Fed tax of approx. $19-24k, which could be paid $10k next year and $10k the following year.
Generally speaking, less than a 5-10 year time before retiring or distributing and the math is too unknown to say for certain. Many simply like the structure of the Roth for both the tax-free distributions, the lack of Required Mandatory Distributions at age 72 and the efficient legacy gifting to beneficiaries.
The Roth is the best structure available, but tough to get significant dollars into it. This is also the same for Roth 401k conversion. If your company offers a "Roth 401k" contribution option in it's Plan, seriously consider it. The Roth 401k doesn't have any income limitations, the Roth IRA does.
Comments
Post a Comment