The financial fallout from the COVID-19 crisis might create a once-in-a-lifetime opportunity to do Roth conversions at an affordable tax cost and gain some insurance against future tax rate increases. In this column, I’ll explain why I say that. But first some necessary background information. Here goes.
Roth IRAs have three big advantages

Let’s quickly review them.

Tax-free treatment for qualified withdrawals

Unlike withdrawals from a traditional IRA, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free too. What is a qualified withdrawal? It’s one taken after you’ve met both of the following requirements:

1. You have had at least one Roth IRA open for over five years.

2. You have reached age 59½, become disabled, or become dead.

To meet the five-year requirement, start the clock ticking on the first day of the tax year for which you made your initial contribution to any Roth account. That initial contribution can be a regular annual contribution or it can be a contribution from converting a traditional IRA into a Roth account.

• Example: Five-year rule.

You opened up your first Roth IRA by making a regular annual contribution on 4/15/17 for your 2016 tax year. The five-year clock started ticking on 1/1/16 (the first day of your 2016 tax year), even though you did not actually make your initial Roth contribution until 4/15/17. You’ll meet the five-year requirement on 1/1/21. From that date forward, you can take federal-income-tax-free qualified Roth IRA withdrawals. Those will include withdrawals from a new Roth account that you establish this year by converting a traditional IRA into a Roth — as long as you are 59½ or older on the withdrawal date.

Required minimum distribution (RMD) rules don’t apply to original Roth IRA owners

With a traditional IRA, you must start taking annual required minimum distributions (RMDs) from the account after reaching age 72. Those RMDs will be at least part taxable (depending on whether you made any nondeductible traditional IRA contributions over the years). In contrast, you can leave any and all Roth accounts set up in your name untouched for as long as you live, and they can keep earning tax-free income and gains all the while.

Key point: One of the tax relief measures included in the CARES Act suspended the RMD rules for 2020.

Roth IRAs are tax-smart wealth transfer vehicles

The aforementioned tax advantages make the Roth IRA a great vehicle for accumulating wealth that you want to leave to your heirs. After you depart the scene, your Roth IRA beneficiary, or beneficiaries, must follow the same RMD rules that apply to inherited traditional IRAs. But those rules are pretty favorable.

If your surviving spouse is the sole beneficiary of your Roth IRA, he or she can treat inherited the account as his or her own Roth IRA. That means your surviving spouse can leave the account untouched for as long as he or she lives.

If a nonspouse beneficiary inherits your Roth IRA, he or she can leave it untouched for at least 10 years. As long as an inherited Roth account is kept open, it can keep earning tax-free income and gains.

• Example: Roth IRA as estate planning vehicle

Rich is age 65 when he converts his substantial traditional IRA into a Roth account in 2020. He lives 12 more years and never takes any withdrawals from the Roth IRA.

Rich’s wife Selma is age 70 when Rich dies. Selma inherits Rich’s substantial Roth IRA as the sole account beneficiary. According to the current IRS life expectancy table, Selma can expect to live another 17 years. She treats the inherited Roth IRA as her own account, which means she does not need to take any RMDs during her lifetime. Being tax savvy because she faithfully reads all my MarketWatch columns, Selma leaves the Roth IRA untouched.

At age 87, Selma passes away and leaves the Roth IRA to daughter Tatum, who was designated as the new account beneficiary when Selma took over Rich’s account. Tatum is 50 years old. She must liquidate the inherited Roth IRA within 10 years after Selma’s death. But Tatum is not required to take any withdrawals before the 10-year deadline. Under current law, any withdrawals taken by Tatum will be federal-income-tax-free qualified distributions. Since Tatum is tax-savvy like her parents, she withdraws nothing until she hits the 10-year deadline.

Following the Roth conversion strategy allowed our imaginary family to accumulate federal-income-tax-free income and gains in the Roth account for a whopping 39 years: 12 years with Rich, 17 years with Selma, and 10 years with Tatum.
Is this the perfect storm for Roth conversions?

It might be, but you must understand that a Roth conversion is treated as a taxable distribution from your traditional IRA. You are deemed to receive a payout from the traditional account with the money then going into the new Roth account. So, doing a conversion will trigger a bigger federal income tax bill for the conversion year, and maybe a bigger state income tax bill too. Despite the conversion tax hit, right now might be the best-ever time to convert a traditional IRA into a Roth IRA. Here are three reasons why.

1. Low current tax rates

Today’s individual federal income-tax rates might be the lowest you’ll see for the rest of your life. Thanks to the Tax Cuts and Jobs Act (TCJA), rates for 2018-2025 were reduced. The top rate was reduced from 39.6% in 2017 to 37% for 2018-2025. However, the rates that were in effect before the TCJA are scheduled to come back into play for 2026 and beyond. But rates could get jacked up much sooner than 2026, depending on events, politics, and to help the federal government recover some of the trillions of dollars spent in response to the COVID-19 pandemic. Believing that rates will only go back to the 2017 levels in the aftermath of COVID-19 might be optimistic. Maybe way too optimistic.

2. Your 2020 tax rate might be much lower than usual

You won’t be alone if your 2020 income takes a hit from the COVID-19 crisis. If that happens, your marginal federal income-tax rate for this year might be lower than what you expected just a short time ago. Maybe much lower. A lower marginal rate translates into a lower tax bill if you convert your traditional IRA into a Roth account this year.

But watch out if you convert a traditional IRA with a large balance — say several hundred thousand dollars or more. The conversion would trigger lots of extra taxable income, and you could wind up paying federal income tax at the top three rates of 32%, 35% and 37% on a big chunk of that extra income. You might owe state income tax, too. That said, paying 32%, 35% and 37% (plus state income tax if applicable) might seem like the “good old days” before too long.

• Example 2: Consider multiyear conversion strategy, but beware of tax-rate risk

Say you are single and expect your 2020 taxable income to be about $100,000. Your marginal federal income tax bracket for this year is 24%. Converting a $200,000 traditional IRA into a Roth account this year would cause most of the extra income from converting to be taxed at 32% and 35%.

But if you spread the $200,000 conversion 50/50 over 2020 and 2021 (which you are allowed to do), most of the extra income from converting would be taxed at 24% and the remainder at 32%. This assumes your 2021 taxable income before any extra income from converting remains at about $100,000.

Obviously, having most of the extra income from converting taxed at 24% and the rest at 32% is better than having most of it taxed at 32% and 35%.

Warning: This example assumes that our current federal income-tax rate regime stays in place through 2021. Will it? Nobody knows, because it depends on events and politics. As we have recently discovered, completely unexpected events can occur at any time.

3. Lower IRA balance after stock market shock means lower tax cost to convert

Just a short time ago, the U.S. stock market averages DJIA, 1.71% were at all-time highs. Then COVID-19 happened, and the averages took major hits. Depending on how the money in your traditional IRA was invested, your account might have taken a major hit, too. Nobody likes seeing their IRA balance go south, but a lower balance means a lower tax cost when (if) you convert your traditional IRA into a Roth account. When the investments in your Roth account recover, you can eventually withdraw the increased account value in the form of federal-income-tax-free qualified Roth IRA withdrawals. If you leave your Roth IRA to your heirs, they can do the same thing (see Example 1).

In contrast, if you keep your account in traditional IRA status, any account value increase from now on will be treated as high-taxed ordinary income when it is eventually withdrawn. As mentioned earlier, the current maximum federal income-tax rate is “only” 37%. What will it be five years from now? 39.6%? 45%? 50%? 55%? Nobody knows, but I bet it won’t be lower than 37%.
The bottom line

If you do a Roth conversion this year, you will be taxed at today’s “low” rates on the extra income triggered by the conversion. And you will avoid the potential for higher future tax rates (maybe much higher) on all the post-conversion income and gains that accumulate in your new Roth account. That’s because Roth withdrawals taken after age 59½ are totally federal-income-tax-free, as long as you’ve had at least one Roth account open for more than five years when withdrawals are taken.

If you leave your Roth IRA to an heir, he or she can take tax-free qualified withdrawals from the inherited account as long as it has been open for more than five years.

• The current tax cost of converting is “low” by recent historical standards, and that may be even more true this year if your income takes a hit due to COVID-19.

• Converting allows you to avoid the potential for higher tax rates in future years on the income and gains that accumulate in the Roth account after the conversion.

• Roth IRAs are great estate planning vehicles.

That amounts to a perfect storm for the Roth conversion strategy.

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