At KHA, we tend to look for opportunities that can be found in challenges. With the COVID-19 crisis, we ask, “What can we learn from this situation or how can we improve our current circumstances?” The values of most retirement plans are lower, and for a lot of the population, taxable income is projected to be lower in 2020. What kind of tax planning can we implement in a year where income is less? 

Comparison of Roth IRAs and Traditional IRAs

Roth IRAs were established in 1997 by a combined effort of Republicans and Democrats. The after-tax IRA was named after William Roth, a former Delaware Senator. Mr. Roth was known for his investigations into the famous $640 Pentagon toilet seats and his desire to encourage Americans to be savers, not spenders. 

A Roth IRA is a retirement account that invests after tax dollars into a savings or investment account. The earnings grow tax free and, in retirement, the distributions are tax free. Traditional IRAs, as a general rule, are funded with pre-tax dollars and in retirement are taxable to the recipient. 

At age 70½ or 72 (the rules changed with the SECURE Act), the owners of Traditional IRAs are required to take a minimum distribution each year to draw down their accounts. Roth IRAs do not have this requirement.   

The beneficiary will have a minimum distribution, subject to certain requirements, upon the death of the IRA account owner.  For simplicity purposes, the Required Minimum Distribution (RMD) could be up to 5 years, 10 years, or the account owner’s lifetime. For a detailed explanation of this, please visit the IRS website at: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds. RMD rules on inherited IRAs and inherited Roth IRAs are identical. 

Tax Savings Opportunities

What circumstances are favorable for a conversion of a traditional IRA to a Roth IRA?

  1. The value of the accounts are low,
  2. The marginal tax brackets are low,
  3. The taxable income is lower than the average, and/or
  4. The marginal tax brackets are expected to increase in the future.

All four of these circumstances may be applicable this year. In a year when the value of the account declines dramatically, as could be the case in 2020, the conversion of the account will generate less tax when compared to a year when the value of the account continues to increase.  If converted on a lower balance, which then rebounds, there could be additional significant tax savings. 

One other item to note is that the 10% early distribution penalty is waived for “coronavirus distributions.”  To learn more about this, please read our other post found here: https://khaaccountants.com/covid/business-and-individual-retirement-plans-and-the-impact-of-the-cares-act/.

Assume for a minute that a taxpayer has a $200,000 Traditional IRA account, has 20 years until RMDs are required and then 20 more years of RMDs.  Let’s also assume that the effective tax rate this year up to the distribution period is 20% and the effective tax rate during the distribution period is 27%.

For the first example let’s make the following assumptions:

  • Annual retirement distribution from any retirement account will be 5%,
  • Annual increase in value with no new additional contributions will be 7%, and
  • Annual increase in value over the distribution period is 3%.

Based on the above criteria, account balances in year 40 are approximately:

$373,000 Traditional IRA (tax paid with retirement funds)

$376,000 ½ Converted Roth IRA (tax paid with outside funds at conversion), ½ Traditional IRA

$386,000 Converted Roth IRA (tax paid with retirement funds at conversion)

$488,000 Converted Roth IRA (tax paid with outside funds at conversion)

Please note: the illustration shows the Traditional IRA balances are reduced for income taxes owed during the distribution period while the Roth IRA illustrations show either tax paid at conversion with retirement funds or with taxes paid at conversion with outside funds. This is why the Roth IRA, net of tax starts out at a lower amount compared to the other illustrations and takes a while to recapture lost funds.  It is also critical to reiterate that Roth funds no longer have tax implications where those traditional IRA balances still have underlying tax obligations, further solidifying the potential advantages of a Roth conversion.

In graph form, see the balances below:

The second example is even more impactful. Let’s assume the same $200,000 Traditional IRA account with same tax brackets and growth assumptions but modify the following:

  • Tax on the conversion to a Roth IRA is paid with outside funds,
  • RMDs are taken on the Traditional IRA (based on today’s tables),
  • RMDs are reinvested in an investment account, after paying tax at our assumed tax bracket, and
  • No tax rate is applied to the earnings in the investment account for this illustration, although there will be some type of income tax unless it is invested in only tax-free investments.

Based on the above criteria, account balances in year 40 are approximately:

$1,090,000 Traditional IRA with reinvested proceeds in an outside investment account

$1,220,000 ½ Roth IRA, ½ Traditional IRA with reinvested proceeds in an outside investment account

$1,300,000 Roth IRA   

Please note: the illustration shows the Traditional IRA balances are reduced for income taxes owed during the distribution period while the Roth IRA illustrations show tax paid at conversion with outside funds. It is also critical to reiterate that Roth funds no longer have tax implications where those traditional IRA balances still have underlying tax obligations, further solidifying the potential advantages of a Roth conversion.

In graph form, see the balances below:

To take this illustration one step further, let’s consider that this IRA is now inherited by your child.  Upon inheritance, under current tax law, this child will be required to distribute the full balance within 10 years.  If the account is a Traditional IRA, the child will pay income tax at the child’s rate on the full balance during that 10-year period.  Depending on the tax rates at that time and the earnings of the child, this could reduce the inherited amount by 10-37% (under current tax laws).  If the account is a Roth IRA, the child will not pay tax on the distributions and can reinvest the full balance however they choose, which adds significant value.

In conclusion, the recent changes in our market and economic environment provide unique opportunities for your retirement and estate planning.  Roth IRA conversions should be part of your conversation this year with your trusted financial advisors, attorneys and CPAs.  Every situation will be different.  Reach out to your advisors at KHA for additional information if you are interested in learning more.  These sources are simply included for informational purposes. KHA Accountants, PLLC, its partners and others do not provide any assurance as to the accuracy of these items or the information included therein. As such, KHA Accountants, PLLC cannot be held liable for any information derived from referenced sources. Consult your legal and business advisors prior to making financing decisions. This is intended for illustrative and discussion purposes only.