2021 may be a year for a little creative IRA tax planning.
A Traditional IRA is typically funded with contributions that were made pre-tax into a 401(k) or other employer-sponsored retirement plan and then rolled over to an IRA, or made on a “tax deductible” basis in that the amount contributed was deducted off of the IRA owner’s taxable income on their tax return. Funds invested in a Traditional IRA grow tax deferred, but are taxed as income when the IRA owner withdraws them for retirement income needs.
A Roth IRA, on the other hand, is funded with money that has already been taxed, or after-tax money. Funds held invested in the Roth also grow tax deferred, but the truly attractive benefit of the Roth IRA comes when funds are withdrawn tax free for retirement. As an advisor who has worked with both types of IRAs for many years, I can say, few things are better than the nice tax-free retirement income generated by a Roth IRA. While I won’t go into all of them here, the tax-free income from a Roth provides lots of planning opportunities for retirees, some of which come in unexpected areas such as health care.
A Roth conversion happens when an IRA owner takes money from a traditional (taxable) IRA and transfers it to a tax-free Roth IRA. The conversion from the Traditional to the Roth IRA is taxable as income in the year of the transaction, and because of this, Roth conversions have not been common over the past decade or so, but a number of tax and planning issues have come into alignment, which may make 2021 a year when investors should explore the benefits of a Roth IRA conversion.
The combination of the SECURE Act, passed last spring in response to the COVID pandemic, and the changing of the political guard in Washington, D.C. this week have opened the window of consideration, in my opinion.
The SECURE Act made two important changes to the rules concerning IRAs and Roth IRAs. The first changed the age when a retiree must begin withdrawing money from their IRA, which was 70 ½ but is now 72. The extension of the mandatory withdrawal, most often referred to the as the RMD (Required Minimum Distribution), provides an opening for late 60s and early 70-year-olds to do some extra Roth IRA conversion planning.
The second change in the SECURE Act is the new law repealed an attractive tax rule know as the Stretch IRA. The Stretch IRA enabled beneficiaries who inherited an IRA or a Roth IRA to take taxable, or tax free, distributions over their remaining life time, essentially “stretching” the tax deferral and payments for a generation. The new rule requires both IRAs and Roth IRAs to be fully withdrawn within 10 years of the original account owner’s death, essentially removing 30-40 years of potential tax deferral for younger beneficiaries.
So, with a two-year reprieve on some Required Minimum Distributions (which can never be used for a Roth IRA conversion), and the removal of the stretch IRA provisions, Roth IRA conversions deserve another look.
The motivating factor behind this second look is the likelihood that under the new Democratic regime in Washington, it's likely the attractive tax rates put in place under the prior administration will drift higher, but due to COVID, not until next year.
Using a bit of math and some reasonable assumptions, I think it may be possible to do a type of tax arbitrage, where through a Roth conversion in 2021, investors, especially those given a reprieve from the RMD, can choose to pay taxes in the current low-rate environment, while anticipating higher tax rates for themselves or their beneficiaries down the road.
It's hard to overstate how attractive the current tax laws are for families in the $80,000 to $125,000 of income range, which happens to be a very common range for many retirees. By using a Roth IRA conversion to fill up these attractively low tax brackets and essentially moving money into the tax haven of a Roth IRA, it may be possible to avoid less attractive tax rates for both retirees and their ultimate beneficiaries in the future.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
