When Life Gives You Lemons…

– by Matthew Beardwood, CFP®, Director of Wealth Management

“Life handed him a lemon,
As Life sometimes will do.
His friends looked on in pity,
Assuming he was through.
They came upon him later,
Reclining in the shade
In calm contentment, drinking
A glass of lemonade.”[1]

We’ve all heard that saying, and there is no better time than now to turn those lemons into lemonade. I think we would all agree that the stock market has soured recently, but there is a silver lining: the Roth IRA conversion just got less costly for IRA investors.

Corona Virus and the Great Conversion Opportunity

Some of you may remember an article I wrote touting the benefits of a Roth conversion (see the article I’m a Believer). I won’t go through all the benefits again, but here are the 3 biggies:

1. Roth IRA withdrawals provide you with tax-free income.
2. There are no Required Minimum Distributions.
3. Roth IRAs pass to your heirs with the same tax-free withdrawal rights you had.

When you convert your traditional IRA to a Roth IRA, the pretax traditional IRA funds used to convert will be included in your income in the year of the conversion.

That is a tax hit, for sure, but keep it in perspective. Consider this, the extra income you report and the corresponding income tax you must pay are only for the year of the conversion. The trade-off will be the years of tax-free benefits you and your family will enjoy in the years which follow. All your Roth IRA funds, including the earnings, will be tax-free when earned inside the Roth IRA as well as when you withdraw them. Not a bad deal!

Why do a Roth Conversion Now?

A Roth IRA conversion done when the market is down is a bargain. Remember, your tax bill is calculated on the value of the traditional IRA funds you used for the conversion. Convert now when IRA values are low and reap the benefits of tax-free earnings and withdrawals later, when the market bounces back.

In addition to taking advantage of downturns in volatile markets, there is another compelling reason to convert now. The Tax Reform Act of 2017 lowered tax rates for many, but these historically low rates will not be here forever. Under the Act, they sunset in 2026.

No one knows for sure what the future will bring. But with large deficits as far as the eye can see, and especially after the $2 trillion coronavirus rescue package, many advisors (including the principals of Westover Capital) believe future income taxes and rates will inevitably be higher. Much higher.

Not sure? Consider this: Even before that $2 trillion-dollar coronavirus congressional commitment, both Joe Biden and Bernie Sanders had proposed raising income tax rates if they are elected. Not after 2026, but next year. Further, if the Democrats also control the Congress after the election, then higher taxes for many are a certainty. And should Donald Trump be reelected, even he may have to raise taxes to deal with all the red ink spilled in this rescue bill.

Converting now is a way to lock in today’s low rates, and a sound way to avoid worries about the uncertainty of those potential, future tax increases.

Thinking conversion may be the right move? Ask yourself three questions. First, when will my IRA money be needed? If you need your IRA money immediately for living expenses, converting may not be for you. Second, what is your effective tax rate? If the income you report this year is lower than your regular income is, that may also favor conversion now. Third, do you have the money to pay the tax on the conversion? You need to pay the conversion tax from non-IRA funds.

Converting now is a way to lock in today’s low rates, and a sound way to avoid worries about the uncertainty of those potential, future tax increases.

Not sure about converting? The good news is that conversion is not an all-or-nothing decision. You can always hedge your bets and do a partial conversion.

Is Conversion Right for You?

Should everybody convert? No, of course not. Conversion is not one size fits all. Also, remember that conversions are now permanent. Are you the right candidate? Is now the time for your conversion? Grab a lemonade, and let’s talk.