While we hope for an end to the current pandemic, there may be a silver lining during this time of disruption.
Many people will be paying less taxes in 2020 either because of the loss of income from a job lay-off or for retirees age 72 or older, because of the suspension of their taxable required minimum distributions from their retirement accounts for 2020.
And many of these same people own stocks in their company retirement plan or IRA that are down in value due to the recent severe market drop.
This creates a golden opportunity to convert a pre-tax IRA to a tax-free Roth IRA (or pre-tax 401-K to a Roth 401-K if the company allows it) with less taxes, and if the market rebounds, and you own stocks in your IRA, you will in effect be getting your Roth IRA at a bargain price.
For example, let's say you have a pre-tax IRA invested in stock mutual funds that were valued at $30,000 at the market peak in February of this year. And today the value is $24,000.
Let’s also assume you are married filing a joint return and have reduced taxable income either through a job lay-off and/or because of the suspension of your required minimum distribution.
To make it an even sweeter scenario, let’s say that this reduction in your income reduces your tax bracket from 22% to 12% with projected taxable income of $55,000 for 2020.
You can convert the $24,000 pre-tax IRA to a Roth IRA and pay tax on $24,000 in a 12% bracket instead of your former 22% bracket.
The end result is it would cost you $2,880 in tax to do the conversion instead of the $5,280 it would cost you in the 22% bracket. And if the market rebounds to its pre-crash level your IRA is now worth $30,000 again.
If this happens, the end result will be you get what equates to an extra $6,000 in your Roth IRA without paying taxes on it. And the tax you do pay is less than it would be in other years, when your tax bracket would likely be higher.
Tax Rates Going Higher
Even beyond 2020, longer term tax rates are likely to be higher than where they are now making future Roth conversions more expensive, if you wait too long.
One reason for this is because our current more favorable tax brackets are scheduled to expire after 2025 and return to 2017 levels, with five of the seven tax brackets going higher.
In addition, our current deficits and the recent $2 1/2 trillion dollar plus Coronavirus stimulus package will also add to the upward pressure on tax brackets, as the government looks for sources of tax revenue to pay these deficits down.
Return Those RMDs
If you already took your required minimum distribution, or what you thought was your required minimum distribution, and you don’t need the money, you may now wish to return it since they are not required for this year. Then if it makes sense, it could be used in a far more tax efficient way, by converting some or all of it to a Roth IRA.
There are two possible ways to put the RMD back. The most certain way is if the RMD distribution took place within the last 60 days and you haven’t already done your one IRA rollover that you’re allowed to do for each 365 day period.
In this case you can simply write a check for the RMD amount and put it back into the IRA before the end of the 60-day rollover period.
If you took the RMD very early in the year and you have gone past your 60-day rollover window there is still another possible approach to put it back.
If you can show that you have been impacted by the COVID-19 crisis enough to qualify under the liberal guidelines for the withdrawal of up to $100,000 under the recently passed CARES Act, this would allow you to put up to a $100,000 of your RMD back into the IRA.
Lemons or Lemonade?
While it’s everyone’s hope to see the Coronavirus come to an end and stocks to go back to their previous highs and beyond, in the meantime a carefully planned Roth conversion this year may be a way to turn lemons into lemonade.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.