Salary cuts, stock market declines and low tax rates provide strong incentives for Roth IRA conversions.

HISTORICALLY LOW TAX rates make 2020 an ideal time to convert traditional individual retirement accounts into Roth IRAs. Now the coronavirus-induced market crash has increased the benefits of converting your traditional IRA to a Roth.

Here is why now may be the ideal time to initiate a Roth IRA conversion:

  • Low tax rates.
  • Stock market decline.
  • Reduced income could drop you into a lower tax bracket.
  • A smaller tax bill for heirs.

With a traditional IRA, you don’t pay taxes on the money you deposit, but withdrawals are taxed as ordinary income. With a Roth, you deposit money on which you’ve already paid taxes, so the money you withdraw in retirement is not taxable. A Roth IRA conversion means you pay tax on your savings in the year you move your money from the traditional retirement account to the Roth in order to set up tax-free income later in life. Your Roth distributions will eventually be a tax-free source of retirement income. If you convert to a Roth IRA in a year when you pay an unusually low tax rate, you can avoid getting hit with higher taxes when you take distributions in retirement.

Low Tax Rates

Historically low tax rates make 2020 a great time to convert your traditional IRA to a Roth account. “It’s the best time in history to convert to a Roth,” says Elijah Kovar, co-founder of Great Waters Financial in Minneapolis. “Between now and 2025, the last year of tax reform, taxes are on sale.”

When you convert to a Roth IRA you pay the taxes now at your current tax rate so you don’t have to pay a higher tax rate in retirement. You can also convert part of your retirement savings and maintain both pre- and post-tax retirement accounts. “A Roth conversion is arguably a powerful tax diversification tool for financial planning,” says Matt Sadowsky, director of retirement and annuities at TD Ameritrade. “The current environment makes it even more attractive to those considering a Roth conversion as part of their financial plan.”

Many people put money in a traditional IRA or 401(k), defer taxes and plan to take distributions in retirement while in a lower tax bracket, but not everyone pays a lower tax rate in retirement. “That is not true for anybody who has saved a significant amount of money,” Kovar says. “Clients many times end up in a higher tax bracket. Between Social Security, pensions and required minimum distributions, people often remain in the same tax bracket they were in before they retired or are pushed into a higher one.”

Stock Market Lows

The down stock market should not deter you from making the switch to a Roth IRA. Stock market lows can be an incentive to convert to a Roth and pay taxes when your portfolio is down.

For example, if you had $10,000 in a traditional IRA at the end of last year, and it was reduced by 30% in the market downturn, “You have the opportunity to pay taxes on that $7,000, convert those shares into Roth and then buy the same $7,000 in shares inside the Roth. When that $7,000 in stock rebounds into $10,000, that growth is tax free,” Kovar says. “The taxes you have to pay is the rate on the reduced share price. Two years down the road, when the market is recovered, you have $10,000 and it’s in a tax-free account.”

Switching to a Roth account in a down market can also help you reposition a portfolio that was not well-diversified. “The value of your securities is lower,” says Nick Yrizarry, president and CEO of Align Wealth Advisors in Laguna Hills, California. “You have relatively low capital gains consequences to sell and move down to a more diversified strategy.”

Reduced Income Results in a Lower Tax Bracket

Many Americans have experienced job loss, pay cuts, furloughs and early retirements. This means that incomes will be lower this year for many Americans, making a Roth conversion more attractive. “The valuations of assets are down with the market lower,” Sadowsky says. “And income arguably will be much less this year as the result of layoffs and the economy materially contracting. Those are two very important considerations when thinking about a Roth conversion.”

You need to pay income tax on a Roth IRA conversion at your current tax rate. If you drop into a lower tax bracket due to a lower income, you will pay less income tax on the amount you convert. Consider a married couple who expected to make $100,000 this year, but one spouse was furloughed due to the coronavirus crisis, and as a result their taxable income drops to $70,000. The couple has effectively dropped from the 22% tax bracket to the 12% bracket. “They could do a $10,000 Roth conversion and only pay 12% when they are normally in the 22% bracket because their income is $30,000 lower,” Kovar says.

Reduced Taxes for Heirs

The SECURE Act, which took effect in 2020, eased some 401(k) regulations, but tightened rules considerably when it comes to inherited 401(k)s and IRAs. Under the old rules, a 45-year-old who inherited a $500,000 IRA from a parent could take small distributions over his lifetime. The new law requires that all distributions be taken within a decade. “Now they have to take the entire amount over 10 years, and $50,000 a year likely puts them in a higher tax bracket,” Kovar says.

If you don’t want to leave your heirs with a big tax bill, it makes sense to convert to a Roth. “The question is, ‘Will I be in a lower tax bracket than my beneficiaries?'” Kovar says. “If so, it makes sense to pay off the IRS under the lower tax rates.”


Sign up for my newsletter!

With my latest news and features