As two of the most widely used vehicles for retirement savings, traditional IRAs and Roth IRAs are both designed to facilitate long-term investment and provide tax advantages. However, one of the key differences between them lies in when they are taxed. Traditional IRAs are funded with pre-tax dollars: you receive a tax deduction when you contribute, but pay income taxes on withdrawals later. With Roth IRAs, you are taxed on the money used to make contributions, but are able to take tax-free withdrawals of both the account principal and growth in retirement.
Generally, Roth IRAs are only available to investors who earn less than $139,000 per year for single filers, or $206,000 for married couples filing jointly. Since 2010, however, the federal government has allowed investors to convert their traditional IRAs into Roth IRAs regardless of their income. Although a Roth conversion is a taxable event, it can serve as a powerful tax diversification tool that allows investors to significantly reduce their tax burdens in the future. Due to the following factors, the current economic environment may be the right time to consider a Roth conversion:
- Tax rates are historically low. When converting a traditional IRA to a Roth IRA, you pay taxes on the account at your current rate. Following enactment of the Tax Cuts and Jobs Act (“tax reform”) in 2017, income tax rates in the U.S. are now historically low. However, these rates are currently set to increase again in 2026—and considering the staggering budget deficit, which has been exacerbated by the recent $2 trillion stimulus package designed to mitigate harm from the coronavirus crisis, there is ample reason to expect that the low rates will not be extended. Therefore, if you believe that your income tax rates may rise in the future, performing a Roth conversion now will enable you to pay taxes on the account at a lower rate and enjoy tax-free withdrawals later.
- The stock market is currently low. As the coronavirus pandemic brought the economy nearly to a halt, the stock market crashed and has yet to fully recover. Therefore, the value of your traditional IRA has likely declined—which means that when converting it to a Roth IRA, you will be taxed on a lower amount than you would when the stock market is robust.
- You are not required to take minimum distributions from your traditional IRA in 2020. Typically, you must begin taking required minimum distributions (RMDs) from your retirement accounts when you reach a certain age (if you were 70 1/2 by 2019, you must begin taking RMDs, but if you reach age 70 1/2 in 2020 or later, you can wait until April 1 of the year after you turn 72). However, in order to create flexibility and tax relief for retirees, the Coronavirus Aid, Relief and Economic Security (CARES) Act suspended the requirement to take distributions in 2020. Refraining from taking RMDs will reduce your taxable income, thereby keeping you in a lower tax bracket—which means that you’ll be able to perform a Roth conversion at a more favorable tax rate. In addition, you will be able to convert a larger amount to enjoy tax-free growth as the stock market recovers.
- Roth conversions offer an alternative to stretch IRAs following changes under the SECURE Act. In the past, investors who wanted to leave a legacy to their heirs—particularly their grandchildren and great-grandchildren—would use an estate planning tool called a stretch IRA. This strategy allowed beneficiaries to take small withdrawals from the original account owner’s IRA over a long period of time, which would minimize taxation and maximize the IRA’s tax-free growth. However, the recently enacted SECURE Act effectively eliminated stretch IRAs by requiring that non-spousal beneficiaries withdraw all of the account assets within ten years. Since Roth IRAs consist of after-tax dollars, beneficiaries who inherit them do not have to pay tax on withdrawals. Therefore, converting your traditional IRA to a Roth IRA offers a solution for providing heirs with tax-free income.
While the current environment presents an opportune time for many investors to consider a Roth conversion, the efficacy of this strategy depends on a variety of factors, including your current and expected future tax rates. As with other significant financial moves, it is important to consult with your tax and financial advisors before converting your traditional IRA to a Roth IRA. Contact our tax diversification specialists today to determine if this strategy is right for you!
-Stephanie Vance, J.D.
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.