2020 - Time for a Roth Conversion?

by Michelle Cross, CFP®, CPA, CDFA®, AIF®
Wealth Advisor

Unless you’ve been completely out of communication with the world for the last two months, you’ve heard about all of the financial support our government is pumping into the economy to keep it from collapsing.  The CARES Act provided $2 trillion of aid to individuals and businesses, the largest stimulus package in U.S. history.  Concern about whether that would be enough has driven the House to approve another $3 trillion through the HEROES Act.  That bill is now being debated within the Senate.

While the government acted swiftly and necessarily, one may ponder where all of this extra money is coming from.  Essentially, we are borrowing it from ourselves.  When annual government spending exceeds revenues, the difference adds to our (annual) federal deficit.  National debt (the total of all the annual federal deficits) is at historical highs in nominal dollar terms but it begs the question: 

How do our current annual deficit levels compare to previous times of crisis and on a more personal level, how do tax rates fit into the big picture?

RothConversionChart TaxRateUSDeficit

As a percentage of GDP, the U.S. annual federal deficit reached its maximum peak in the mid-1940s (World War II).  Notice that during that time, the highest marginal income tax rate jumped from 25% to a whopping 94% and stayed at that level until the 1960s when the Tax Reduction Act was passed.  We can only assume that the increase in tax revenue contributed to the decline in the deficit.  But as we’ve continued through the last 30 years with historically low tax rates, the deficit has crept up.  Check out the Congressional Budget Office’s projected deficit as a percentage of GDP for 2020, which is reflected as a dotted black line in the chart above.

With all of the additional debt the government is currently taking on to prop up the economy during the coronavirus pandemic, it seems to be only a matter of time before tax rates are raised significantly again.  Of course we don’t know when and if that will happen but we do know that the IRS gave us a small gift this year by suspending required minimum distributions for 2020.  Typically, an IRA owner over 72  would have had to take a specified minimum amount (RMD) out of his/her pre-tax IRA and include that as taxable income for the year.  Because that requirement has been lifted for 2020, we generally expect retirees’ taxable income to be lower this year.  

Therefore, this year may be a great opportunity to convert some of that pre-tax IRA money into Roth IRA money. 
 
When you convert any portion of your pre-tax IRA to a Roth, you will be taxed on the amount converted.  However, once it’s in the Roth IRA, you won’t have to pay taxes on that money again and you aren’t required to take withdrawals from it during your lifetime.

Does it make sense to convert now?

Let’s look at a married couple, ages 73 and 67, who live off of Social Security and withdrawals from their taxable brokerage account.  The 73-year-old has a large pre-tax IRA and a smaller Roth IRA.  Every year, he has to take RMDs from the pre-tax IRA and include those amounts in taxable income even if he doesn’t need the money for living expenses.  Since those RMDs are fully taxable, when tax rates increase in the future, more of his retirement savings will be going to the IRS and he’ll get to keep less for himself and his family.  So, he can elect to pull income into 2020 by converting a portion of his pre-tax IRA to Roth and that might reduce the taxes he’ll pay later on.

Also, remember that in this scenario, the wife is younger than the husband.  If he were to pass away unexpectedly, his wife would be able to treat both IRAs as her own.  She could defer taking an RMD from the remaining pre-tax money until she reaches age 72.  Furthermore, she would not have to take any RMDs from the Roth IRA during her lifetime, leaving it to grow for the next generation.     

Of course every family situation is unique and converting to Roth may not make sense for everyone.  If you have questions and want to review your individual plan, please contact your Allegiant Wealth Advisor.