Converting traditional IRA assets to a Roth IRA is a tried-and-true strategy for creating a tax-free source of retirement income. The catch is that converted assets are taxed as ordinary income in the year of the conversion.
The resulting tax bill could be painful, especially for someone with a thriving business or a professional in his or her peak earning years. On the other hand, 2020 may be an unusual tax year for many small-business owners and investors who have suffered financial losses due to the pandemic.
If you have retirement savings in a traditional or SEP IRA and a long-term perspective, a Roth conversion might help you turn misfortune into opportunity. Here’s why.
You might pay higher taxes in retirement. Distributions from your tax-deferred retirement accounts are taxed as ordinary income, and the lower federal tax rates passed in 2017 are scheduled to expire at year-end 2025. A Roth conversion could provide a hedge against future tax increases — a possibility that seems more likely in the wake of soaring government spending on pandemic relief measures.
Qualified withdrawals from a Roth IRA are free of federal income tax and may be free of any state income tax that would apply to retirement plan distributions. Generally, a Roth distribution is considered “qualified” if it meets a five-year holding requirement and you are age 59½ or older (other IRS exceptions may apply).
Having a pool of tax-free income available in retirement might also help you stay below income thresholds that could trigger additional investment taxes or Medicare premium surcharges.
You could have beaten-down assets to convert. Financial markets were volatile in 2020, but some industries — and some of your portfolio positions — may have been hit harder than others. Assets that have fallen in value are good candidates for a conversion because you could convert more shares for each tax dollar and would have more shares in the Roth account to pursue tax-free growth in the years ahead.
You might take advantage of net operating losses (NOLs) from a pass-through business. The additional income generated by a Roth IRA conversion can be offset by losses and deductions reported on the same tax return. Unlike net capital losses, which are limited to $3,000 annually, NOLs have no limits. Thus, a large NOL (from 2020 or carried forward from a previous tax year) could potentially eliminate any tax consequences from a Roth conversion up to the same amount.
You don’t have to convert a large IRA all at once. One strategy is to “fill your tax bracket,” meaning you would convert an amount that would keep you in the same tax bracket. Whether your conversion is small or large, it’s generally better if you can pay the tax with savings held outside of your retirement accounts. Taking extra money from the IRA to cover the taxes results in additional taxes and may also be subject to the 10% early-withdrawal penalty prior to age 59½.
Analyzing your current financial situation and projected retirement income can help determine whether it would be beneficial to convert some of your IRA assets at the lowest tax rates in a generation, rather than paying taxes on distributions in retirement. Keep in mind that it might be easier and less risky to make conversion decisions near the end of the year, when you have a more precise estimate of your income, business losses, tax burden, and investment performance.
Finally, be sure to consult with a tax professional before taking any specific action.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.