Originally By Rodney Brooks, US News Money, March 19, 2021
Edited for clarity and brevity by Gleba & Associates

Low tax rates provide strong incentives for Roth IRA conversions.

The impact of the pandemic along with low tax rates makes 2021 an opportune time to convert a traditional individual retirement account into a Roth IRA. But a Roth IRA conversion may not be the right financial move for everyone.

A Roth IRA conversion makes sense when:

  • Taxes are low.
  • Your income is reduced.
  • You have the money to pay the taxes that become due.
  • You don’t want to leave heirs a big tax bill.

With a traditional IRA, you don’t pay taxes on the money you deposit, but withdrawals are taxed as ordinary income. With a Roth, you deposit money on which you’ve already paid taxes, so the money you withdraw in retirement is not taxable. A Roth IRA conversion means you pay tax on your savings in the year you move your money from the traditional retirement account to the Roth in order to set up tax-free income later in life. Your Roth distributions will eventually be a tax-free source of retirement income. If you convert to a Roth IRA in a year when you pay an unusually low tax rate, you can avoid getting hit with higher taxes when you take distributions in retirement.

Low Tax Rates

Historically low tax rates make 2021 a great time to convert your traditional IRA to a Roth account. “It’s the best time in history to convert to a Roth,” says Elijah Kovar, co-founder of Great Waters Financial in Minneapolis. “Between now and 2025, the last year of tax reform, taxes are on sale.”

When you convert to a Roth IRA you pay the taxes now at your current tax rate so you don’t have to pay a higher tax rate in retirement. You can also convert part of your retirement savings and maintain both pre- and post-tax retirement accounts. “A Roth conversion is arguably a powerful tax diversification tool for financial planning,” says Matt Sadowsky, director of retirement and annuities at TD Ameritrade. “The current environment makes it even more attractive to those considering a Roth conversion as part of their financial plan.”

Many people put money in a traditional IRA or 401(k), defer taxes and plan to take distributions in retirement while in a lower tax bracket, but not everyone pays a lower tax rate in retirement. “That is not true for anybody who has saved a significant amount of money,” Kovar says. “Clients many times end up in a higher tax bracket. Between Social Security, pensions and required minimum distributions, people often remain in the same tax bracket they were in before they retired or are pushed into a higher one.” If you need to take large withdrawals from a traditional retirement account in retirement, you could even be pushed into a higher tax bracket, which could have unexpected consequences. For example, Medicare beneficiaries could face higher premiums because Medicare premiums are based on your income.

Reduced Income Results in a Lower Tax Bracket

Many Americans have experienced job loss, pay cuts, furloughs and early retirements. This means that incomes will be lower for many Americans, making a Roth conversion more attractive. “Income arguably will be much less this year as the result of layoffs and the economy materially contracting,” Sadowsky says.

You need to pay income tax on a Roth IRA conversion at your current tax rate. If you drop into a lower tax bracket due to a lower income, you will pay less income tax on the amount you convert. Consider a married couple who expected to make $100,000 this year, but one spouse was furloughed due to the coronavirus crisis, and as a result their taxable income drops to $70,000. The couple has effectively dropped from the 22% tax bracket to the 12% bracket. “They could do a $10,000 Roth conversion and only pay 12% when they are normally in the 22% bracket because their income is $30,000 lower,” Kovar says.

You Have the Money to Pay the Taxes

While it can make sense to initiate a Roth IRA conversion when your income is down and you are perhaps in a lower tax bracket, a period of unemployment may not be the optimum time to do a Roth conversion if you don’t have enough cash on hand to pay the taxes that will be due on the amount you convert. “You have to have money to pay for the income taxes,” said Eric Bond, a wealth advisor and president of Bond Wealth Management in Long Beach, California. “You really need to spend time with a tax preparer. Make the decision later in the year to get a good estimate of how much your taxes might be before you do it.” For some people, it might be better to do a rollover after you retire, assuming your income will be lower. Once you convert, you don’t want to be surprised by a sky-high tax bill.

It’s important to note that you don’t have to convert your traditional IRA all at once. “Some people think it is all or nothing,” Bond says. “You can gradually convert 10% a year for 10 years.”

Reduced Taxes for Heirs

The SECURE Act, which took effect in 2020, requires many traditional IRA beneficiaries to withdraw all the money in the account within 10 years and pay the resulting tax bill. Under the old rules, a 45-year-old who inherited a $500,000 IRA from a parent could take small distributions over his lifetime. The new law requires that all distributions be taken within a decade. “Now they have to take the entire amount over 10 years, and $50,000 a year likely puts them in a higher tax bracket,” Kovar says.

If you expect the IRA to be part of your estate, determine if your children are in a higher tax bracket than you. It might make sense for you to convert to a Roth now if you are in a lower tax bracket than your beneficiaries. “They will then receive the IRA proceeds without having to worry about the taxes,” Bond says. If you don’t want to leave your heirs with a big tax bill, it makes sense to convert to a Roth.