Please note that this blog is based on laws effective on August 4, 2020 and may not contain later amendments. Please contact Cray Kaiser for most recent information.
As hard as it has been financially for many individuals, the year has provided some unique tax opportunities for those who have traditional IRA accounts. These range from converting traditional IRAs to Roth IRAs, retirees making larger-than-normal IRA withdrawals and the decision whether to take advantage of the required minimum distribution suspension for 2020. Let’s look at these prospective tax strategies to see if they might apply to you.
Conversion of a Traditional IRA to a Roth IRA
The reason you might want to convert your traditional IRA to a Roth IRA is that a Roth IRA provides tax-free accumulation and tax-free distributions once you reach retirement age. A traditional IRA provides tax deferral of earnings, and the distributions are taxable.
Since distributions from a Roth IRA are not taxable but those from a traditional IRA would be, you generally pay tax on the amount converted. After all, the government isn’t going to allow both the tax deduction when contributing to a traditional IRA and tax-free withdrawal from the Roth on the converted amount. Thus, a conversion provides the most benefit in a year when your income is low, and as a result, you have a lower tax rate. Timing here is key, and 2020 may be a low-income year when you might find it appropriate to convert some portion of your traditional IRA to a Roth IRA.
Consider this example: you are normally in the 32% tax bracket but find yourself in the 12% tax bracket for 2020 due to the COVID-19 pandemic. That means you can convert some portion of your traditional IRA to a Roth IRA at a tax cost of only 12% (or $120 per $1,000 converted) as opposed to $320 per $1,000 under normal circumstances.
When considering a conversion, one concern is where the money to pay the conversion tax comes from. Generally, it must come from separate funds. If it is taken from the IRA being converted, for individuals under age 59½, the funds withdrawn to pay the tax will also be subject to the 10% early distribution penalty in addition to being taxed.
Conversions can be tricky, and once made, they cannot be undone. If you reside in a state with state income tax, the conversion may also be taxable by the state. If you are considering a conversion, contact Cray Kaiser so we can help you analyze your options or develop a conversion plan.
Required Minimum Distribution Suspension
If this was a typical year, 2020 required minimum distributions (RMDs) would be required by taxpayers who turned age 70½ prior to 2020 or reach age 72 in 2020. But due to the impacts of COVID-19, the government has suspended the requirement for certain older taxpayers to take RMDs from their retirement plans and traditional IRAs. But just because the requirement to take RMDs has been suspended, it doesn’t mean you shouldn’t take a distribution in 2020. That decision should be based on two issues:
1) Your need to pay for living expenses
2) Sound tax planning
Issue number one speaks for itself. However, there are times when your income is low compared to normal, and it may be beneficial from a tax perspective to take a distribution even if you are not required to. This may be true even if you aren’t of an age for the RMD to apply. In these situations, the amount of a distribution can be coordinated with your tax liability to provide a beneficial tax outcome. In some cases, the distribution could even be free from tax or at least subject to a tax substantially lower than in a normal year.
Generally, this strategy is for individuals older than 59 ½ and not subject to the 10% early withdrawal penalty. However, there are times when paying the 10% penalty may even be worth it for younger individuals when the tax saving is large enough.
It is important to understand that we are talking about retirement funds. Just because they can be taken out of a traditional IRA or qualified plan for a low tax rate, it doesn’t mean they shouldn’t be set aside in a savings account for future retirement needs.
Among all of the other changes this year, these IRA opportunities for 2020 could be easily overlooked. It can also be complicated to figure out the conversion or distribution amount to optimize the tax benefits. If you have questions or would like assistance, please don’t hesitate to contact Cray Kaiser. We’d be happy to help you.