Good Time to Convert Traditional IRAs to Roth IRAs?

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It might be a little painful, but it may be worthwhile to check on your pre-tax IRAs during this dip. If you have been thinking of converting your “Traditional” IRAs over to Roth IRAs, your shrunken gains will lead to a smaller tax bill now, while your (hopefully) future gains from this point onward will be tax-free after 5 years and age 59.5.

Roth IRAs have a few unique benefits like a lack of minimum required distributions, but the primary consideration regarding conversions is still whether you think your tax rate will be lower today or when you withdraw. This is outlined in greater detail in the WSJ article A Strategy for Taking Advantage of the Market Meltdown (paywall?). One interesting suggestion is to convert just enough money from a traditional IRA to make full use of your current income-tax bracket. Here are the 2020 IRS marginal tax brackets (source) – remember the left column is adjusted gross income so it comes after subtracting the standard deduction of $12,400 (single) and $24,800 (joint).

Depending on your income situation for 2020, you might have a good amount of room to convert and pay a 10%, 12%, or 22% rate. For example, a married couple could make up to $105,050 in gross income (before the standard deduction) and still be in the 12% bracket. You get the most tax-deferred benefit if you can pay for your tax bill with external funds as opposed to the IRA balance itself.

Backdoor Roth IRAs. In case you aren’t already aware, you can make a “backdoor” Roth IRA contribution even if you exceed the standard income limits on Roth IRA contributions. This is primarily because there are no longer any income limitations on Roth IRA conversions. There are some finer points that experts debate, but the general idea is that you first contribute to a non-deductible traditional IRA and then quickly convert that to a Roth IRA (ideally with no gains and thus tax owed). One catch is that if you already have other deductible pre-tax IRA balances, then these would mix together and you’d have to pay tax on a pro-rated basis.

Given the recent stock market drop, if you made non-deductible IRA contributions in the past few years, but your “Backdoor Roth” was complicated by also having some other pre-tax IRA balances mixed in (say, from a 401k rollover), then this might be a chance to convert everything over to a Roth IRA with much smaller tax consequences.

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  1. As a New Yorker speaking to a Hawaiian (Hawaii and Wyoming are the only two states not to have experienced a single COVID-19 death yet), I would say: Now is the time to forget about your IRA, traditional or Roth, and focus every iota of your energy on making sure each and every mamber of your community is complying with social distancing. If you are healthy and 20 years old or so, consider “adopting” one or two elderly or infirm neighbors for whom you can buy groceries and who you can call each morning and evening to make sure they are doing well and have everything they need.

    • I appreciate the sentiment, and we are definitely supporting social distancing and local healthcare providers, in addition to also doing all activities (grocery shopping, picking up drugs, etc) for elderly relatives so that they don’t have to leave their house at all. But people still have to find time to love, laugh, eat, work, and take care of their finances. This is going to be a long fight. We are still waiting for our leaders to realize the need for widespread testing (even if it means bad publicity) and contact tracing.

  2. I took some advantage of this a couple years ago. I quit my job once again and travelled for two years. During the second year, I had no income so converting traditional to Roth would be the only thing that would get taxed. Of course, that also meant that I had to pay taxes on it, however small. That was the thing I had to wrestle in terms of how much to convert vs how much of my dwindling cash stash I was willing to part with vs continue traveling. The point of converting up to the limit of one of the tax brackets is also an interesting suggestion.

  3. I think I read somewhere that under the new relief act one can take up to $100,000 out their IRA tax free as long as they replace it within 3 years. I do not have a Roth IRA. If this is true I am wondering if I could take out $100,000 from my IRA over 3 years and create a Roth IRA and then replace the $100,000 with cash from my savings at the due date 3 years later. I would create a tax free Roth IRA.

    Since I am over 71 I also wonder if I can use my RMD over 3 years and not owe taxes to achieve this. Finally, if all this is true, does it seem like a good idea? Hopefully, I will never need the Roth and would leave it to my family.

    • I believe you have to be “affected” by COVID-19 in order to do this. I’m sure there are guidelines someplace to define “affected” . Roth IRA contributions (not rollovers) are required to come from earned income.

    • I kind of see where you are coming from, but don’t see how you could convert to a Roth IRA without creating a taxable event. You can’t just contribute $100k to a Roth using the proceeds from a loan, either.

  4. We have been doing this for the last 3 years. While it is painful to pay the tax, you will have to pay it sooner or later anyway. I’d like to say if there is a silver lining this year, might as well convert as many “shares” while the market is down and have the gain grow back tax free. Maybe one note: I believe you cannot access the Roth funds for 5 years after conversion. I am thinking that is what I read – we dont’ plan to withdraw from the Roth, so haven’t done a deep dive on that issue. While there was a big push to contribute and at the time it sounded great to invest before tax funds on the theory that once retired, one would be in a lower tax bracket, I don’t think that is going to be the case for those who diligently invest their funds. Also, I am not sure the RMD is emphasized heavily enough either. Although the age of the RMD was recently increased to 72 from 70, I know plenty of people waiting until they are 70 to get the “highest” social security payout and then, now 2 years later, they have to start taking RMDs and paying taxes, there are folks who diligently and with luck have millions in their fund – their tax burden may be higher than expected. Also read many horror stories of people thinking they are leaving $XM as a legacy only in reality, if they weren’t taking their RMDs on traditional funds; there is a 50% penalty, plus taxes owed. I think it should be regulated and the RMD sent to the owner of the funds so that they are atleast not liable for the 50% penalty since a discussion of RMDs, etc is usually not discussed by employers, or the employee is not paying attention, etc. I think the big push now is ROTH contributions instead of the “Traditional” which probably is a better option.

  5. I don’t know for certain but one thing to keep in mind is that since Roth conversions are treated as income, it may affect your ability to collect the recent stimulus payments if the conversion pushes you over the limit ($99k individual, $198k MFJ).

    • I’m not 100% sure on this either, but from what I’ve read, the stimulus check is based on 2018/2019 income and does not have a clawback provision if you make more than the limit in 2020.

      • I interpret what I have read the same way you do. But I do want to say that since we have been converting now for several years (especially since the tax rates dropped) what Bill says is true. We do not qualify for the stimulus check, but I guess another silver lining is that we don’t have pay the taxes on the converted amount until July 15.

  6. I just found “Coronavirus stimulus package offers relief for retirees with RMD waiver and penalty-free 401(k) withdrawals”. So people have another reason to convert IRA to Roth because ROTH convert amount has to be after RMD amount.

  7. Jonathan — can you do a traditional IRA to convert to a roth (backdoor) if you already have a 401k from employer. I’ve read that you can’t have trad ira when you already have an employer 401k… then how would do you backdoor roth?

    • Yes, you can contribute to a non-tax-deductible Traditional IRA when you have a 401k. You can also convert from Traditional IRA to Roth IRA with a 401k.

      The thing you can’t do is convert *just* the non-deductible portion of Traditional IRA to a Roth IRA, while keeping your other pre-tax Traditional IRA balance (which you didn’t pay tax on yet) separate. They are considered to be converted together on a pro-rated basis, so there may be some issues from paying extra taxes.

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