The Roth IRA Conversion: Is It the Right Move for You?

The Roth IRA Conversion: Is It the Right Move for You?

I generally consider myself a pretty optimistic guy. I really do!  If I get stuck in traffic, I see it as an opportunity to listen to more of my favorite talk radio show instead of getting frustrated. I believe the Patriots can advance in the playoffs this year, even without Tom Brady. And I like to find the silver lining in any situation. As I sat in traffic this week, listening to the sports radio talk about the Patriot’s canceled game because of “COVID-Cam”, I remained optimistic.

Hmmm . . . then I got to thinking.  

You know, I got thinking about how having optimism can translate to our finances. And that during these challenging times that COVID-19 has brought us, there may actually be a promising financial opportunity for many of us. As we’ve all seen, the financial markets are as volatile and unpredictable as ever and unemployment numbers and bankruptcy filings are hovering around all-time highs.  But even with all the bad economic news, we are hearing about companies and business sectors that are not only surviving, they are thriving. Businesses like Amazon and Instacart, with strong home delivery markets, are finding demand for their services exploding. And companies that offer an alternative to going out for exercise or entertainment. While gyms and fitness chains struggle, the high-end home bike exercise company, Peloton, has seen a 66% revenue increase in 2020. And while the stands at sporting events are virtually empty, video game companies are reporting 20% sales increases during COVID. 

Within the financial advisory and service industry, the hot “opportunity” these days is Roth IRA conversions.  For many people, the opportunity to convert their traditional IRA to a Roth IRA is a great move. The big advantage of Roth IRAs is that while contributions are made with after tax money, all qualified withdrawals (once you’re age 59-1/2 and the account is at least 5 years old) are completely tax free. This differs from the traditional IRAs, which allow tax deductible contributions, but the withdrawals are taxable. Another benefit of a Roth IRA is the ability to take early penalty free withdrawals of contributions at any time, so you have a level of liquidity in the account.

Because so many people are finding their current traditional IRAs down in value or they are concerned about potential unfavorable future tax policies, financial services firms and advisors are seeing large year over year increases in Roth IRA conversions.  One large firm, Fidelity Investments reported a 67% increase in conversions through the first four months of 2020.  The looming 2020 elections may be adding fuel to the activity, as some people fear that a democratic win for president and the senate may mean higher tax brackets.  

So, if you have money in a traditional IRA, you are allowed to “convert” this into a Roth IRA. This will allow you to enjoy the tax-free benefits I just noted – but nothing in life is free, right? The downside of a converting a traditional IRA to a Roth IRA is that it creates a taxable event for you in the year of the conversion. The money moving out of your traditional IRA is added to your taxable income for the year. But, because so many folks are seeing economic difficulty year, a Roth conversion can minimize the potential taxable impact and negative consequences of doing a conversion right now. If your holdings in your traditional IRA have suffered this year, that could lessen the potential impact a conversion would have on your taxable income. Additionally, the same would be true if your income is down this year, particularly if you’re a small business owner that will experience a business loss that could offset part or all of the amount of the traditional IRA you would be liquidating as part of the conversion. 

Despite the fact that Roth IRA conversions seem to be appropriate for so many people this year, they are not right for everyone.  For those who haven’t seen a significant decline in the value of their traditional IRA or those whose incomes haven’t suffered a loss, there can be hidden traps in converting to a Roth IRA.  Doing even a partial conversion can have tax consequences, such as pushing you into a higher tax bracket.  

For example, the conversion could cause increased premiums for your Medicare parts B and D. The increased income from a conversion could result in a Medicare surtax.  Also, on the health care front, increased income could result in the loss of the Affordable Care Act advance tax premium credit.  For those using the deduction of itemized medical and dental costs that exceed 7.5% of their AGI (adjusted gross income), an income increase would lessen that deduction.

A Roth conversion that moves you from a lower 10% or 12% federal marginal tax bracket to the 22% marginal tax bracket may result in capital gains taxes up to 15%. And if you are already collecting Social Security, increased income may mean more of your Social Security benefits would be considered taxable.  This could mean that up to 85% of your benefits are taxable.

Even something that seems as inconsequential as moving could create a significant negative financial impact. For example, if you plan on moving to a high income tax state like California, you could face a in stiff state tax bill, particularly if you were previously in a state with a low income tax rate, or none at all (like Texas or Florida). So, my message to you this week is this, keep your optimism alive and well and take advantage of the silver linings that the pandemic can offer – but make your financial decisions with a clear head and all the facts.

And as always folks – be vigilant and stay alert, because you deserve more!

Have a great week.

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield & Southlake, TX. Jeff can be reached at jeff@cutterfinancialgroup.com.

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