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The recently passed SECURE Act changed the retirement landscape, hurting the attractiveness of inherited IRAs for many people. But the legal changes actually make it more favorable – combined with historically low federal tax rates – to convert a traditional IRA into a Roth IRA.
Here’s why it might make sense to convert to a Roth IRA and why you may need to act fast.
The SECURE Act makes Roth IRAs better
There were many provisions in the SECURE Act – including raising the age for required minimum distributions for retirement plans – but one of them was key for beneficiaries of IRAs. The new law changed how much time many non-spouse beneficiaries of an IRA can take before they have to empty the account, and they now must close out an inherited IRA within 10 years.
Under the old plan, distributions from an inherited IRA could be taken over the beneficiary’s lifetime. While inheritors had to take a required minimum distribution each year, they could stretch those distributions over a longer time frame. In a traditional IRA, that meant a beneficiary could minimize withdrawals and therefore the tax impact and let the account grow over time.
Now with just 10 years until inherited IRAs must be closed out, a beneficiary has to realize income from a traditional IRA more rapidly and take a tax hit on it. However, new distribution rules don’t require annual minimum distributions, only that the IRA be empty at the end of 10 years.
“The result will most likely be a quicker depletion of the inherited IRA but also more of the inherited IRA going to taxes, especially if the beneficiary is working during the time in which they have to spend down this IRA,” says Bill Van Sant, senior vice president and managing director at Girard, a wealth management firm based in the Philadelphia area.
One solution: Those planning their estates can convert a traditional IRA into a Roth IRA to eliminate future tax impacts and leave their heirs a tax-free inheritance.
“The original IRA owner will begin converting all or part of their IRA into a Roth IRA during their lifetime,” says Van Sant. “Although upon the original owner’s passing, the beneficiaries will still have to deplete the Roth IRA within 10 years, there will be no tax consequences [for the inheritors] as distributions from Roth IRAs are not subject to federal taxes.
“The longer the funds have the opportunity to grow tax-free, the more powerful this benefit has the potential to become,” he says.
The current tax environment makes this strategy especially appropriate. Federal rates on income, capital gains and estate taxes are among the lowest they’ve ever been, says Jeffrey Corliss, managing director and partner at RDM Financial Group at Hightower in Westport, Connecticut.
“The timing to investigate a Roth conversion is especially critical now, before the current tax legislation sunsets at the end of 2025,” says Corliss. “Given the COVID-19 relief provided by the government and the increased budget deficit, it is highly likely that income taxes, including capital gain rates and estate taxes, could increase in the future.”
Politicians need not wait until 2025 to change rates, so it may make sense to act soon.
What else you need to pay attention to
Converting your traditional IRA to a Roth IRA may be a good course of action, but you do need to run the numbers to see if it makes sense to do so. It’s important to remember the following factors as you’re considering whether or not to pursue this opportunity further.
1. There are exceptions to the SECURE Act
While the SECURE Act eliminated the stretch IRA for many beneficiaries, the stretch IRA is still a possibility for many others. Surviving spouses, for example, can still take advantage of a stretch IRA, but so can a few other groups, says Corliss.
Other groups include a disabled or chronically ill individual, beneficiaries who are not more than 10 years younger than the original account owner and minor children, but Corliss says that “the child only can stretch the distributions until they reach the age of majority, which depending upon the state [where] they live can be 18-21, at which time the 10-year depletion rule starts.”
That list of exceptions also includes some trusts and charities.
2. Your tax bracket matters
Any amount of money that’s converted from a traditional IRA to a Roth IRA will be subject to taxes. So it’s important that you consider your tax situation when looking at this option, not only what you pay now (or could pay at a higher bracket) but what you might pay in the future, too.
“You may want to pay the taxes on the converted amount while you are in a lower tax bracket if you think your tax rate will be higher down the road,” says Van Sant.
And since 2020 has been a year of layoffs and reduced income, it could be a good time to convert and minimize the tax impact, says Corliss.
Investors considering this approach have another strategy: Convert their IRA over a few years to control the tax impact in any one year. This strategy may prevent you from going into a higher tax bracket and paying extra taxes on that realized income. Corliss suggests maximizing the conversion amount while minimizing or staying below the threshold for the next tax bracket.
3. Pay additional taxes from outside funds
If you do convert, you’re going to owe taxes and probably a lot, since you never paid taxes on the income that went into the traditional IRA in the first place. And you’ll need the cash to do so.
Corliss warns: “You want to pay the taxes due on the conversion from outside assets and not from the converted IRA assets. Due to penalty issues, it is never better to pay with funds from the IRA being converted, especially if you are under [age] 59 ½.”
In fact, he suggests that if you have to pay taxes from the IRA funds, then the conversion probably doesn’t make sense.
4. Seek the help of a professional tax adviser
This kind of conversion – and the calculus to figure it all out – is complex, so it’s tremendously helpful to have a financial adviser or tax adviser who is familiar and comfortable with these issues to help you sort them out. A good adviser will help you make the right decision, even if the decision is not to convert. Your focus is to minimize taxes here.
“Given the change to the stretch IRA provision in the SECURE Act, doing a Roth IRA conversion may make sense and is at least worth looking into with your tax adviser,” says Corliss. “It may save you or your heirs many dollars in income taxes.”
Ultimately, you’ll have to decide whether it makes sense for your own financial situation.
Featured image by Sam Edwards of Getty Images.
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