Edward A. Zurndorfer

The Tax Cuts and Jobs Act of 2017 (TCJA) lowered individual tax rates for the period 2018 through 2025. For many individuals, the lower tax rates have been most beneficial. On the other hand, the coronavirus-induced stock market recent plunge has been brutal, especially for those individuals whose retirement accounts such as IRAs are invested in equities/stocks and stock mutual funds.

But for traditional IRA owners whose accounts are invested in equities and which may have lost as much as 15 to 25 percent of their value over the last two months, there is a silver lining; namely, perhaps a good time to convert their traditional IRAs to Roth IRAs. In so doing, the IRA owner will ideally reduce income tax bills in retirement. Before discussing why now may be a good time to initiate a Roth IRA conversion, it is important to review the differences between traditional IRAs and Roth IRAs.

With a traditional IRA, the IRA owner may or may not pay taxes on the funds contributed to the IRA. With a deductible traditional IRA, the contributions are made with pre-taxed dollars, resulting in an immediate tax deduction (adjustment to income) for the amount of the IRA contribution. With a nondeductible traditional IRA contribution, the contributions are made with after-taxed dollars, meaning that there are no immediate tax savings during the years in which contributions are made. With both a deductible and a nondeductible traditional IRA, any earnings grow tax-deferred and are taxed only when the accrued earnings are withdrawn. The withdrawal of traditional IRA earnings occurs in retirement when the IRA owner is presumably in a lower overall tax bracket. With a deductible traditional IRA, the contributions are also taxed when withdrawn.

With a Roth IRA, contributions are always made with after-taxed dollars (there are no “up-front” tax savings when a contribution is made to a Roth IRA) and earnings grow at least tax-deferred. The contributions are always withdrawn tax-free because they were taxed before they were contributed. The accrued earnings are withdrawn tax-free if the earnings are withdrawn via a “qualified” Roth IRA distribution. A “qualified” Roth IRA distribution means that the Roth IRA owner has fulfilled two requirements at the time of withdrawal; namely: (1) the Roth IRA owner is at least age 59.5; and (2) it has been at least five years since January 1 of the year the Roth IRA owner made his or her very first Roth IRA contribution.

With a Roth IRA conversion, a traditional IRA owner pays income tax on the accrued earnings (and pre-taxed contributions in the case of a deductible traditional IRA) of the traditional IRA. The taxes are paid in the year of the Roth IRA conversion in order to set up tax-free income later in retirement. By converting a traditional IRA to a Roth IRA, a traditional IRA owner will hopefully avoid being subject to higher income taxes had the IRA owner not converted the traditional IRA to a Roth IRA and then paying taxes on the traditional IRA withdrawals in retirement.

There are four reasons why currently may be an ideal time to perform a Roth IRA conversion, as now discussed:

Lower Federal Income Tax Rates

As a suggestion to save on taxes, perhaps an ideal time to convert a traditional IRA to a Roth IRA is when income tax rates are low. Starting Jan. 1, 2018 and through Dec. 31, 2025, federal marginal income tax rates have decreased as a result of the passage of the TCJA. Unless Congress takes action, federal income tax rates will revert back to the higher individual federal marginal income tax rates in effect during 2017, inflation adjusted. In short, taxes are “on sale” for the next six years as a result of TCJA passage.

The current lower tax rate environment is one of the factors with respect to determining whether or not a Roth IRA conversion is justified. When an individual converts a traditional IRA to a Roth IRA, the individual pays taxes in the year of conversion at his or her current year marginal tax rate. The goal is to pay a lower tax now so that he or she does not have to pay a presumably higher tax in retirement when the traditional IRA is withdrawn, had a Roth IRA conversion not taken place. But many individuals think the opposite. They think their taxes are higher now compared to what they will be in retirement. They therefore contribute to a deductible traditional IRA or the traditional TSP while working, benefitting from tax-deductible contributions, deferring taxes, and making taxable withdrawals in retirement when they in a lower marginal tax bracket. That may not be true for individuals who have saved a significant amount of money for retirement. These individuals could end up in a higher marginal tax bracket. Between CSRS and/or FERS annuities, military pensions and/or private pensions, Social Security, TSP and IRAs, many federal annuitants often remain in the same tax bracket they were before they retired, or they are pushed into a higher tax bracket in retirement.

The current lower federal income tax rates, in effect through 2025 but then scheduled in 2026 to revert back, make the argument for Roth IRA conversions now more plausible, especially because for those employees who are looking to retire from federal service within the next five to 10 years, they will be withdrawing from their TSP and IRAs after 2025.

“Down” Stock Market

A “down” or depressed stock market should not deter a traditional IRA owner from converting a traditional IRA to a Roth IRA. On the contrary, a depressed stock market can be an incentive to perform a Roth IRA conversion and pay less income tax as a result of a stock portfolio that has decreased in value.

For example, suppose a traditional IRA owner had a traditional IRA invested mainly in stocks and whose value was $20,000 as of 12/31/2019, but because of the recent stock market downturn, the value of the IRA has reduced 20 percent with the traditional IRA worth $16,000 as of 4/30/2020. If the traditional IRA owner were to convert the IRA to a Roth IRA as of 4/30/2020, then the IRA owner will pay taxes on the $16,000. After the conversion and assuming the Roth IRA currently worth $20,000 eventually rebounds to $20,000 and more, the growth will be tax-free. Assuming the IRA owner is in a 22 percent federal marginal tax bracket, the owner saved 22 percent of $20,000 less $16,000, $4,000, or $880 in federal income taxes by converting on 4/30/2020 rather than on 12/31/2019. 

Reduced Income May Result in a Lower Marginal Tax Bracket

Many individuals have experienced a job loss, a pay cut, a furlough or an early retirement as the result of the COVID-19 pandemic. While federal employees have not lost their jobs nor have there been any furloughs as a result of COVID-19 pandemic, there are some federal employees who are married to spouses who have been laid off or furloughed. The valuation of many financial assets are down, interest rates are down, and what this means is that many employees’ investment income amounts will likely decrease during 2020. Total income arguably will be less in 2020 compared to 2019 for many employees and annuitants, likely resulting in lower marginal tax brackets for many employees.

A traditional IRA owner needs to pay income tax on a Roth IRA conversion at his or her current marginal tax rate. If in a given year the IRA owner drops to a lower marginal tax bracket as a result of a decrease in taxable income that year, then the IRA owner will pay less income tax on the amount of the IRA being converted. For example, a married couple who expected initially early in 2020 to have taxable income of $100,000 during 2020 but one spouse was furloughed due to the COVID-19 pandemic. The result is that their 2020 taxable income is expected to decease to $70,000. The couple has effectively dropped from the federal 22 percent marginal tax bracket to the 12 percent marginal tax bracket. If one spouse does a $10,000 Roth IRA conversion, then the spouse will pay 12 percent of $10,000, or $1,200 in federal income taxes, rather than 22 percent of $10,000, or $2,200, a saving of $1,000 in federal income taxes.

Reduced Taxes for Heirs

The SECURE Act (which took effect on Jan. 1, 2020) tightened the rules with respect to inherited IRAs. Under the old (pre-SECURE Act) rules a child, say 45 years old, who inherited a $500,000 traditional IRA from a parent and subject to mandatory required minimum distributions (RMDs), could take the RMDs spread over the child’s life expectancy, thereby receiving smaller amounts of the traditional IRA each year and most probably paying a smaller amount of tax over the child’s lifetime. Under the SECURE Act, the inherited traditional IRA must be distributed in its entirety within 10 years of the parent’s death. In the example above, receiving $50,000 a year for ten years from a fully taxable traditional IRA could push the child into a higher marginal tax bracket for at least some of the 10 years.

Those federal employees and annuitants who are parents of grown children and who do not want to leave their children or other relatives with a big tax bill may want to seriously consider converting their traditional IRAs to Roth IRAs. Or if they have traditional TSP accounts and they are over age 59.5, start transferring their traditional TSP account to Roth IRAs. Parents should ask themselves: “Will I be in a lower tax bracket than my heirs?” If the answer is “yes”, then the parents should seriously consider converting their traditional accounts to Roth accounts at a time that is financially favorable to them, which, for many parents, may be at this time.

   Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.