Why you might consider a Roth conversion in 2020

2020 offers some unique planning opportunities for those who would’ve normally taken a Required Minimum Distribution (RMD) from their retirement accounts. Before we get too much further, here’s a quick recap of what happened with RMDs this year: in March, Congress released the CARES Act, which has a whole bunch of interesting provisions to help people who are struggling financially due to coronavirus. Even if you’re not struggling yourself, there are some useful things to be aware of, like how RMDs are waived in 2020. (Fun side note: they also waived RMDs in 2009 because… well, we all know what happened there.)

In other words, the IRS is giving you a free pass this year. This is really only helpful if you have outside savings and investments to the point that it renders your RMD a tax nuisance. If you follow conventional wisdom and decide to give your retirement accounts a rest this year, your money would be left alone to continue growing tax-free, and you wouldn’t be hit with a tax bill.

While deferring RMDs for 2020 makes a lot of sense on the surface, we started to wonder if there could be a better solution for the long-term. What if, instead of accepting the waiver Congress extended to us, we take the money out anyways? We were going to have to pay the tax regardless, if it hadn’t been for the coronavirus. Better yet, what if we take the money out as a Roth conversion? This would presumably lower future RMDs, which lowers future tax obligations. (Spoiler alert: there’s other benefits, too.)

 We looked at several client cases to test our theory, and it turns out that Roth conversions in the amount of your normal RMD do make sense, particularly for people who fit this fact pattern:

• They don’t need their RMD this year to cover living expense
• They have non-qualified (cash) assets to pay the tax bill associated with the Roth conversion
• They’re expected to have excess assets at the end of their life

If this sounds like you, we’d be more than happy to run the numbers for you and give you a sense of the impact it could have over your lifetime. But, to expand a little more on the idea, consider:

1. You were going to have to pay the tax anyways. Converting your normal RMD this year won’t cause your tax return look materially different than it did in 2019, or than it will in 2021.
2. Your RMD amount every year is calculated as a fraction of last year’s ending balance. By removing dollars from your retirement account, you’re lowering the balance, which lowers next year’s RMD, which lowers next year’s taxes ever so slightly.
3. The important thing to understand is that every RMD in future years will be lower, such that your incrementally lower taxes, over a decade or more, end up saving you a considerable amount of money.
4. There aren’t any RMDs for Roth accounts, so the amount you convert will continue to grow—assuming you don’t need to tap into it, which plays off our third fact pattern criteria above.
5. Especially important for people who are concerned with leaving their heirs the most tax-efficient assets as possible: a Roth is much more advantageous than a traditional retirement account like an IRA or 401(k). All of the accounts mentioned will need to be distributed within 10 years by the inheritor, but since Roth distributions are free of tax, you heirs could presumably distribute 100% of the account in year 10, giving the Roth assets the longest amount of time to grow, tax-free.
6. Though it’s hard to speculate on future tax rates, we are in a historically low-tax environment right now. It’s not farfetched to assume that taxes will go up, so converting some funds to a Roth and paying the tax now could be a savvy move.

As with most things in financial planning, your mileage with this strategy may vary. But, we think it’s worthwhile for a lot of people to consider. If we can help in any way, always feel free to get in touch.