Year-End 2020 Tax News & Planning Strategies
Should You Convert to a Roth IRA in 2020?
One of the many questions we are receiving from clients is if they should convert their traditional IRA to a Roth IRA before the end of the year. In general, a Roth IRA is beneficial to someone who believes they will be in a higher tax bracket at the time withdrawals will be made. Depending on your 2020 tax position, it may be beneficial to convert traditional IRA funds, pay tax on the conversion amount in 2020, and take tax-free distributions from a Roth IRA in the future. First, let’s discuss the basics:
Roth vs Traditional IRA
When considering a retirement plan that best suits your needs, there are two key differences between Roth and Traditional IRAs. The primary difference is that contributions made to a Roth IRA are after-tax, whereas traditional IRA contributions are made pre-tax. Due to the nature of a Roth contribution, subsequent qualified withdrawals pass to the individual tax-free, making the Roth IRA the ideal choice for those who expect to be in a higher tax bracket when they start taking distributions. Conversely, a traditional IRA would be a better option for someone who expects to be in the same or lower tax bracket when beginning to take distributions. The second key difference is that a traditional IRA has required minimum distributions (RMDs) that are mandatory to be taken after age 72, while a Roth IRA has none.
Who Can Convert Their Plan to a Roth IRA?
Taxpayers who participate in a traditional IRA may distribute and convert the funds to a Roth IRA within 60 days of the distribution. Those who participate in a 401(a) qualified plan can also convert by either contributing to a Roth IRA through a direct rollover or distributing funds and contributing to a Roth IRA within 60 days. Individuals who participate in a qualified 401(k) or 403(b) plan which maintains a qualified Roth contribution program are eligible to make an in-plan Roth rollover. Please remember to consider that a switch from a traditional IRA or qualified plan to a Roth IRA is not tax-free – the amount you convert will be added to your gross income in the year in which you make the conversion and you will pay tax on the amount at your ordinary rate. However, the conversion is generally not subject to the 10% premature distribution tax.
Why It May Be Advantageous to Convert Your IRA in 2020
The Roth IRA will qualify for tax-free distributions of contributions and earnings if you meet a 5 year holding period beginning in the year that the first Roth contribution was made and when the individual is age 59½ or older. Qualified Roth distributions will not increase taxable income and may prevent taxpayers from moving to a higher tax bracket or allow taxpayers to avoid certain phase outs which are triggered by higher adjusted gross income in the future. In contrast, the distributions from traditional IRAs (if taken in 2020) will increase the current year adjusted gross income.
In summary, those who are projected to be in a lower tax bracket in 2020 may want to consider taking on the additional income and associated taxes now and allow for tax-free distributions in the future by converting those funds into a Roth IRA. If you have any questions regarding your IRA, we encourage you to reach out to one of our tax specialists.