Converting a Traditional IRA to a Roth IRA

by | Jul 1, 2020

Question:        With the past and perhaps an impending  further drop in the stock market, does it now make sense to convert my traditional IRA to a Roth IRA?

Answer:            The recent stock market drop represents an opportune time to convert an existing Individual Retirement Account (an “IRA”) to a Roth IRA.  If, like most IRA owners, some portion or all of your account is invested in equity positions, the recent stock market drop has resulted in a decrease in the value of your IRA. Because a Roth conversion is a taxable event, the decreased value of your IRA will mean the corresponding income tax obligation you will incur on the Roth IRA conversion will also decrease. Moreover,  if you are investing in the stock market with a long-term prospective and believe the value of the equity positions in your IRA will increase over time,  the current stock market drop may provide a  meaningful tax savings for you.

Roth IRAs offer significant tax benefits to IRA owners.  Most persons making contributions to their traditional IRAs are able to deduct the contributions made. Contributions to Roth IRAs are not deductible; tax is imposed only on the conversion of a traditional IRA to a Roth IRA. Owners of traditional IRAs and Roth IRAs are not taxed on the earnings nor appreciation in the accounts while funds are held in the IRA. The primary difference between the two types of IRAs is how distributions are treated. Distributions from traditional IRAs are subject to tax at ordinary income tax rates when made. Distributions from Roth IRAs are usually not subject to income tax. One other significant difference between the two types of IRAs is that owners of traditional IRAs must commence distributions from their accounts by their so-called required beginning date, April 1 of the calendar year following the calendar year in which they reach age 72.  Owners of Roth IRAs are not subject to these minimum distribution requirements so they may keep their Roth IRA funds intact during the balance of their lifetimes. Both traditional IRAs and Roth IRAs are subject to minimum distribution requirements on the IRA owner’s death although surviving spouses of IRA owners can treat their deceased spouse’s IRA as their own and transfer or rollover the decedent’s account to their own IRAs.

The question that must be addressed is whether a traditional IRA owner should incur the upfront tax cost to achieve the benefits of a Roth IRA. With the onset of COVID 19 and the related economic consequences, Roth IRA conversions seem to be more desirable.  The drop in the value of the stock market is certainly one factor favoring a conversion. Another factor to consider is a likely increase in income tax rates in the future.  COVID 19 has resulted in substantial government spending and may result in larger deficits in the Federal budget than ever before. Tax rate increases may be necessary. A conversion to a Roth IRA at the present time may result in paying income tax on retirement plan assets at potentially lower tax rates.  If you believe the stock market will increase in the future and/or that income tax rates are likely to increase, this may be an optimal time to convert your traditional IRA to a Roth IRA.

Roth IRA conversions are not an all or nothing proposition; a traditional IRA can be converted in whole or in part. Many traditional IRA owners choose to convert their accounts to Roth IRAs over a period of years to avoid the significant up-front tax cost and to avoid some or all of the converted funds being taxed at higher income tax rates. Of course, a future tax increase may motivate many traditional IRA owners to make a full conversion now while tax rates may be lower rather than in the future.

There are many factors to consider in weighing the decision of whether to convert a traditional IRA to a Roth IRA. These factors include whether or not you will be working as a senior, how much taxable income you have from other sources and whether you intend to withdraw meaningful amounts of money from your retirement accounts or just the minimum amount required. A careful analysis of your particular situation should be undertaken to determine if this is an appropriate time to convert your traditional IRA to a Roth IRA.  

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to Bruce Bell.