The coronavirus pandemic has taken its toll on our economy, but as bad as conditions might seem, savvy investors are seeing some good news. In fact, this is a unique circumstance that doesn’t happen very often, and some have been waiting years for a tax savings opportunity like this to come along.
Recent legislation combined with economic mayhem caused by COVID-19 has opened the door to investors looking for opportunities to move their retirement savings from traditional IRAs to Roth IRAs.
So, why is that a big deal?
The Roth IRA advantage comes down to taxes and flexibility. The money we deposit into our traditional IRA has not been taxed, so we see a big bang for our buck going into the account, but when we pull the money out after retirement, Uncle Sam is there, waiting for his share. Money placed in a Roth account has already been taxed, so the money we withdraw stays in our pockets. Meanwhile, Roth IRAs allow us to withdraw our contributions tax-free at any time, as long as the five-year aging requirement has been met and the investor is at least 59½ years old.
Also, under the SECURE Act, which became law in 2019, an IRA could cause financial hardships for children who inherit the account. Under the new law, beneficiaries who are more than 10 years younger than the deceased owner must withdraw the entire inherited IRA balance within 10 years. In most cases they must pay taxes on the money, and the financial consequences could be significant for lower-income inheritors, who may be bumped into a higher tax bracket. Under a Roth account, there is still a 10-year stipulation, but most inheritors do not pay taxes on withdrawals.
Millions of people have IRAs, usually set up as part of a retirement benefit offered by an employer. Many of those people would love to move that money into a Roth account. In the past, though, the taxable amount on such a move would have been very costly. But, for some investors, those circumstances have changed, and that red light has suddenly turned green.
As everyone knows, we pay taxes according to tax brackets linked to our incomes. The more money we earn, the higher the percentage we pay in taxes. The Tax Cuts and Jobs Act of 2017 lowered tax rates across the board for most Americans. For example, a married couple earning $300,000 per year used to be in the 33% tax bracket. Under the new law, the couple pays 24%.
Meanwhile, the economic crisis caused by COVID-19 has reduced incomes across the country, pushing many into lower tax brackets and further opening opportunities for lower-cost conversions.
This window will not be open forever, though. Under the Tax Cuts and Jobs Act, tax brackets will return to their original levels in 2026. The economic downturn will eventually end, and incomes will improve. Financial markets have already recovered substantial ground, and the unemployment rate is dropping. But more economic instability may be ahead as the pandemic continues, and there are many factors that could determine if this is your year for conversion. Investors should consult with a registered investment adviser and a CPA now, so they can be ready to convert if shifting markets create even greater opportunities this fall.
Stacy Murray is a certified public accountant and a member of the team of financial advisers at Oklahoma City-based Full Sail Capital.