As bad as it has been financially for many individuals, 2020 does provide some unique tax opportunities. Specifically for those who have traditional IRA accounts. These range from IRA conversions, to retirees making larger-than-normal IRA withdrawals. Also the decision whether to take advantage of the required minimum distribution (RMD) suspension for 2020.
Let’s look at each of these possible tax strategies to see if they might apply to you.
Unique tax opportunity #1 – Conversion of a traditional IRA to a Roth IRA
The first strategy to explore is converting your traditional IRA account to a Roth IRA account. You may want to consider a Roth IRA as it provides tax-free accumulation. Also once you reach retirement age, Roth IRAs provide tax-free distributions. On the other hand, a traditional IRA provides tax deferral of earnings, and the distributions are taxable.
Since distributions from a Roth IRA are not taxable, you generally pay tax on the amount converted. After all, the government isn’t going to allow both the tax deduction when contributing to a traditional IRA and tax-free withdrawal from the Roth on the converted amount. Thus, a conversion provides the most benefit in a year when your income is low. And as a result, you receive a lower tax rate. But for unique tax opportunities like this, timing is key! With the pandemic disrupting many businesses in 2020 – this may be a lower-income year for you. So it may be beneficial to convert some portion of your traditional IRA to a Roth IRA.
Example of a conversion
Suppose you are normally in the 32% tax bracket. However, you find yourself in the 12% tax bracket for 2020 because of the COVID-19 pandemic. That means you can convert some portion of your traditional IRA to a Roth IRA at a tax cost of only 12% (or $120 per $1,000 converted) as opposed to $320 per $1,000 under normal circumstances.
When considering a conversion, one concern is where the money to pay the conversion tax comes from. Generally, it must come from separate funds. If it is taken from the IRA being converted, for individuals under age 59½, the funds withdrawn to pay the tax will also be subject to the 10% early distribution penalty in addition to being taxed.
Conversions can be tricky, and once made, they cannot be undone. If you reside in a state with state income tax, the conversion may also be taxable by the state. If you are considering this unique tax opportunity, it might be appropriate to call for an appointment. We can help you analyze your conversion options properly or develop a conversion plan that fits your particular circumstances.
Unique tax opportunity #2 – Required Minimum Distribution (RMD) suspension
For 2020, the government has suspended the requirement for certain older* taxpayers to take required minimum distributions (RMDs) from their retirement plans and traditional IRAs. However, just because the requirement to take RMDs has been suspended, doesn’t mean you shouldn’t take a distribution in 2020.
That decision should be based on two issues:
- Primarily, on your need to pay for living expenses, and
- Secondly, sound tax planning.
Issue number one speaks for itself. However, there are times when your income is low compared to normal, and it may be beneficial tax-wise to take a distribution even if you are not required to. This may be true even if you aren’t of an age for the RMD to apply. In these situations, the amount of a distribution can be coordinated with your tax liability to provide a beneficial tax outcome. In some cases, the distribution could even be free from tax. And if not free from tax, at least subject to a tax substantially lower than in a normal year.
RMD – when is a penalty worth it?
Generally, this strategy is for individuals older than 59.5 and not subject to the 10% early withdrawal penalty. There are times, however, when paying the 10% penalty may be worth it. When the tax saving is large enough, this is an option for younger individuals.
It is important to understand that we are talking about retirement funds; Just because they can be gotten out of a traditional IRA or qualified plan for a low tax doesn’t mean they shouldn’t be set aside in a savings account for future retirement needs.
These unique tax opportunities are easily overlooked. And figuring out the conversion or distribution amount to optimize the tax benefits can be complicated. If you would like us to help determine the strategy that best fits your needs, please give this office a call at (360) 778-2901.
*If not for the COVID-19 suspension, 2020 RMDs would be required by taxpayers who turned age 70½ prior to 2020 or reach age 72 in 2020.
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