Roth Conversions: 2020 is the Year

Tax Rates are Likely to Go Up

There’s an election coming. A lot of things could change, including your income tax rate. Given the blowout spending at all levels of government in the wake of the Covid-19 pandemic, the odds strongly favor higher tax rates in the future. Federal tax rates went down with the Tax Cuts and Jobs Act of 2017, but those cuts are already set to expire in 2025. Most Democrats favor repealing the tax cuts sooner than that. And many of them favor setting rates higher than they were before. Some of them also favor eliminating preferential rates for long-term capital gains and corporate dividends. That’s just at the federal level. The same political winds are blowing in most states and municipalities.

The polls are indicating a relatively high likelihood that the Democrats will sweep the election, taking the presidency and both the House and the Senate. Senate democrats have also voiced their intention to get rid of the traditional Senate rule that allows the minority party (likely to be the Republicans) to filibuster legislation they oppose, which in the past has forced some compromise between the two parties. In short, there may be nothing to stop Democrats from dramatically increasing tax rates. They have many priorities that will require a lot of money. In fact, raising taxes itself may be portrayed as reducing income inequality, one of their stated goals.

Lower Taxes Now vs Higher Taxes Later

Most of us instinctively avoid paying taxes sooner when we could pay later. But to minimize your taxes what matters is the tax rate that you pay, not when you pay it. This is based on the mathematical principle called the “commutative” property of multiplication. You probably learned about it in elementary school and have long since forgotten. If “T” stands for the rate of taxation, and A, B and C stand for annual rates of return on your investments, then it doesn’t matter where you insert T into the chain of multiplication, the product will be the same. That is:

             T x A x B x C  =  A x B x C x T

The point is that if you believe your marginal tax rate in the future will be higher than your current marginal tax rate, it may be wise to convert some of your traditional IRA money to Roth IRA money. Once inside a Roth, income tax rates won’t matter to you because your withdrawals will be tax-free. And the capital gains and income that you receive as the money in your Roth IRA grows will also be completely sheltered from taxes, so what happens to tax rates on capital gains and dividend income (currently taxed at much lower rates but on the Democratic chopping block) won’t matter either.  

Usually, those who currently have a tax rate that is lower than what they expect in the future includes people who are in their retirement “gap years.” They have stopped working, or at least substantially reduced their earned income, but they are not yet drawing Social Security or taking required minimum distributions from their IRAs. Consequently, their income is lower than what it will be after age 70 (the highest age for starting Social Security) or age 72 (the age when most will have to start required minimum distributions from their IRAs).

Others may have a temporarily low income because of a job loss, temporary disability, or other change in employment circumstances.  These, along with “gap years” retirees, are prime candidates for Roth conversions.

However, the prospect that tax rates could increase dramatically in the years ahead adds to the attraction of Roth conversions for everyone.

Roth Contributions vs Roth Conversions

There are two ways of getting money into a Roth IRA. The first is through contributions. Annual contributions to IRAs (traditional + Roth) are limited. The sum of traditional and Roth IRA contributions for 2020 cannot exceed $6000 (or $7000 if you are 50 or older).¹ Whereas contributions to a traditional IRA are tax-deductible (reducing your taxable income), Roth contributions are not. In addition, higher income taxpayers are prevented from making Roth contributions at all. For example, married filing jointly taxpayers with an adjusted gross income of over $206,000 may not make Roth IRA contributions.  (The AGI cutoff is $139,000 for single taxpayers.) There are no income limitations limits on traditional IRA contributions. These rules make it difficult to accumulate substantial amounts in a Roth IRA through contributions only.  

The other way of getting money into a Roth is with “Roth conversions.” There are no income limitations on Roth conversions, and there are no limitations on amounts that can be converted. Also, it is not necessary to convert 100% of a traditional IRA to a Roth IRA. It is often optimal to smooth out the taxable income that will be incurred by doing multiple conversions over a period of years.

A Roth conversion refers to the act of “converting” money in a traditional IRA account into money in a Roth IRA account. Usually, contributions to traditional IRA accounts are made with pre-tax dollars, meaning that money was not included in your taxable income at the time of the contribution. But the IRS does not let you off from paying taxes. Any distributions you take from a traditional IRA account are considered taxable income, and that income is taxed at “ordinary” income tax rates, not capital gains rates (which currently are quite a bit lower). In contrast, contributions to a Roth IRA are made with after-tax dollars, and qualified distributions you take from a Roth IRA account are tax-free. In addition, there are no required minimum distributions for Roth IRA accounts. You have complete control as to if and when you take distributions. You can leave your Roth IRA to your heirs and the same tax-free withdrawals will apply to them.

All of this makes money in a Roth IRA account extremely valuable, especially if tax rates go up in the years ahead.  The best way to get substantial money into a Roth IRA is with conversions.

Roth IRA Rules

As with most things having to do with the IRS, there are a lot of rules that apply to Roth IRAs:

Once a Year. IRS rules allow for only one IRA rollover or conversion (of any kind) per year.²

Early Withdrawal Penalty. You can do a Roth conversion at any age, even before age 59 ½, without having to pay the 10% penalty for early withdrawal as long as 100% of the money withdrawn from the traditional IRA goes into the Roth IRA. Any money distributed but not converted into the Roth IRA (for example, used to pay taxes) will be subject to a 10% penalty if you are under age 59 ½.  

Taxes at Conversion. You must pay taxes on the amount converted, taxed at “ordinary income” rates. This may push your marginal rate into a higher bracket. If you are over age 59 ½, you may use some of the distribution from your traditional IRA to pay taxes, but that is rarely a good idea. You would be surrendering valuable tax-sheltered money that would otherwise benefit from a tax-free buildup. Far better to use money outside of any tax-sheltered account to pay the taxes.

The Five-Year Rule.   To encourage long-term saving, IRS rules require you to keep your money in a Roth for at least five “tax years.”   (The clock starts on January 1 of the year of the contribution or conversion no matter when in the tax year the contribution or conversion took place.) Contributions and conversions are treated somewhat differently for purposes of the five-year rule.  Whereas any contribution to a Roth IRA will start the clock for any and all future contributions, each conversion amount has its own 5-year time period³ and thus with multiple conversions there may be multiple different 5-year periods underway at once. Also, when a Roth account from an employer retirement plan is rolled into a Roth IRA (such as from a Roth 401k), the years in the Roth employer plan do not count towards the Roth IRA five-year rule. Instead, the clock starts with the funding of the Roth IRA. ⁴

Rules Governing Distributions. Contributions to a Roth IRA can be withdrawn at any time without tax or penalty, even before satisfying the five-year rule. The five-year rule applies to withdrawals of 1) earnings on contributions, 2) amounts converted from a traditional IRA to a Roth IRA, and 3) inherited Roth IRAs. If you're under 59½ and take a distribution within five years of the conversion, you'll pay a 10% penalty unless you qualify for an exception (death, disability, or first-time home purchase). If you are over 59 ½ and you take a distribution before five years are up, your distribution will be subject to income tax.⁷ The rules can be complex and confusing. According to Investopedia:

“A withdrawal that is tax- and penalty-free is called a qualified distribution. A withdrawal that incurs taxes or penalties is called a non-qualified distribution. Failing to understand the difference between the two and withdrawing earnings too early is one of the most common Roth IRA mistakes.”⁶

You might be wondering if keeping each converted amount in a separate account would be helpful. However, because the Roth rules aggregate together all Roth accounts, there is no need to keep Roth contributions and conversions in separate accounts, or to otherwise try to separate out multiple types of contributions.⁷ Overall, the ordering rules for Roth IRAs stipulate that withdrawals are funded from after-tax contributions first, conversions second (on a FIFO basis), and earnings third. Just remember,  as long as you keep your Roth IRA intact for at least five years and you don’t withdraw until at least age 59 ½, you won’t have to worry about these fine points—all of your withdrawals will be qualified distributions and will be tax-free and penalty-free.

Roth Conversions After RMDs Start. It is possible to still convert money from a traditional IRA to a Roth IRA even after required minimum distributions (RMDs) from the traditional IRA have started.  However, IRS rules do not allow you to convert an RMD. The way to avoid this is to make sure that all RMDs have been taken before any Roth conversions occur.   Otherwise, there will be an improper rollover and contribution to a Roth IRA. To fix this would require pulling the money and all gains out, or doing a recharacterization of an excess contribution. It can be a real mess.⁸

How to Make a Roth Conversion

The IRS offers three possible ways for an individual to convert funds from a traditional IRA into a Roth IRA account. These methods include: 

• Rollover: The custodian of your traditional IRA gives you the funds, often in a check.  You must put the funds into a Roth IRA account within 60 days. This is by far the worst way to do it, and is fraught with pitfalls (like the 20% tax withholding often imposed by custodians which you must make up out of pocket until tax time, failing to open and fund a new account within 60 days, the new custodian rejecting the account for some reason, etc.). The other two ways are far better and safer. 
• Trustee-to-trustee transfer: The institution currently housing your traditional IRA transfers the distribution to a different institution where it'll be held in a Roth IRA. 
• Same trustee transfer: The institution currently housing your traditional IRA is able to also house your Roth IRA, and they roll the account over for you.⁹

You’ll report the conversion to the IRA on Form 8606 when you file your income taxes for the year of the conversion. Check with your financial advisor first, but it’s likely that you will be very glad that you planned ahead and converted some of your traditional IRA money to Roth IRA money while tax rates were low.