Differences Between Traditional and Roth IRAs

The basic premise of a Traditional IRA is that it allows tax-deferred contributions.  This means that if certain criteria are met, taxpayers may deduct the amount of their contributions to their Traditional IRA from their income.  Taxes are paid on Traditional IRAs when distributions are taken.

If income is over a threshold amount, and taxpayers are covered by a qualified employer plan, or some other rule prevents tax deductible contributions, taxpayers may still contribute to a Traditional IRA. These contributions would be considered nondeductible.

Nondeductible contributions create basis in the Traditional IRA, which is important to note and to track on Form 8606 for future benefit.  Traditional IRAs require that a minimum distribution (RMD) be taken when the taxpayer reaches age 72 (the rule prior to 2020 was 70½).  RMDs are only partially taxable if there were nondeductible contributions made.  Then any distributions taken will have a portion that is attributable to basis treated as nontaxable.  The apportionment of taxable to nontaxable depends on the total basis (nondeductible contributions) and the total value of all Traditional, SEP, and SIMPLE IRAs at the end of the year of distribution.

In addition to RMDs, distributions can be made, without penalty, beginning at age 59½.  It is important to note that in general, distributions taken before age 59½ also have a 10% penalty in addition to the ordinary income tax.

Roth IRAs work in almost an inverse way.  Contributions to Roth IRAs are made with after tax dollars, meaning that the contributions are not deductible from income.  The benefit with Roth IRAs is that while contributions grow tax-free like the Traditional IRA, the Roth is different in that all qualified distributions (consisting of contributions and earnings from the Roth IRA) are not taxed when they are withdrawn.  In general, a qualified Roth withdrawal is taken after the account owner has met both of the following requirements: at least one Roth IRA account has been open for over five years, and the account owner has reached age 59½, become disabled, or passed away.

Another benefit of a Roth IRA is that withdrawals are considered to have come from contributions first, so if a taxpayer finds they need to dip into their retirement account before reaching age 59½ (not usually recommended), the 10% penalty and ordinary income tax will only be assessed on amounts related to earnings.

A word of caution, however, when converting a Traditional IRA: each conversion amount has its own five-year waiting period and must satisfy the five-year period rule to avoid the 10% penalty if one of the exceptions above does not apply.

What’s So Ideal About 2020?

The most important item for taxpayers to note is that a conversion of a Traditional IRA to a Roth IRA is a taxable event.  The distribution will be deemed to be received in the year of the conversion.  Some may wonder why a tax professional may recommend a strategy that could result in a larger tax bill.  This strategy all depends on the taxpayer’s personal financial objectives and if the payment of tax, as a result of the conversion, in the near-term results in a larger long-term benefit.

No one has a crystal ball that can see the future.  The Tax Cuts and Jobs Act (TCJA) ushered in some of the lowest personal income tax rates in recent history.  While the TCJA brought the highest individual  tax rate bracket down from 39.6% to 37%, it is slated to go away in 2026.  In addition, with each election cycle there is always the possibility that Congress could decide to repeal or rewrite existing law.  Coupled with the current COVID-19 pandemic and its impact to the economy and recovery efforts, we could see tax rates change sooner rather than later.  Now may be a better time to implement a conversion strategy.

Another reason why 2020 could be an ideal time for a conversion to a Roth IRA is that one’s overall personal income in 2020 may not be as high as it has been in prior years.  Whether investment balances and investment income are down in 2020, companies don’t issue raises or bonuses, or with less overall income from various activities in 2020, this year could be the time to execute a strategy of converting all or some Traditional IRAs into Roth IRAs.

Why does it matter if overall income is less?  Since our tax system is a marginal rate system, which means only the last dollars are taxed at what is traditionally called one’s “tax bracket,” less overall income could mean less of a tax bite out of the conversion.  For example,  let’s say Jane is single and her taxable income is usually $50,000.  In 2020, this would put her in the 22% tax bracket.  The tax due is not 22% of $50,000, rather it is 10% of the amounts up to $9,875, 12% of the amounts between $9,876 and $40,125 and 22% of the amount over $40,125.

Tax Bracket	Range	Jane’s Income	Tax
10%	$0 – $9875	$9875	$987.50
12%	$9876 – 40,125	$30,250	$3,630
22%	$40,126-85,525	$9875	$2,172.50
Totals	—	$50,000	$6,790

Below is an illustration of a Traditional IRA conversion where Jane wants to convert $130,000 of a traditional IRA (assuming contributions were deductible at the time they were made) and a comparison if her income were the same as above or if her taxable income (other than the conversion) were to drop to $30,000.  You can see with a little bit of planning, the tax savings on this particular conversion is over $6,100.

	Income	Traditional IRA Conversion	Total	Tax Bracket	Tax
Income	50,000	130,000	180,000	32%	$38,615.50
Income	30,000	130,000	160,000	24%	$32,475.50
Difference	20,000	0	20,000	8%	$6,140

Looking for one more reason to convert?  Taxpayers who would have been required to take a minimum distribution from an existing Traditional IRA in 2020 have been granted relief from doing so due to special legislation in response to the COVID-19 pandemic.  If an RMD is not necessary for living expenses, 2020 could be an ideal time to convert since the conversion amount can be in lieu of the RMD that is now not required to be taken.  A Roth conversion does not satisfy RMD requirements, however 2020 has no requirement for an RMD.  In fact, taxpayers have until August 31, 2020 to return a previously issued RMD that was taken in 2020.

Conclusion

The current economic and tax climate may be ideal for those over age 59½ and who would like to leave financial resources to heirs and avoid a tax burden to the beneficiaries, or for those looking to capitalize on lower than expected income or avoiding RMDs in the future.

Your conversion should be strategic, and careful consideration should be taken to ensure the tax impact is fully understood and anticipated.  If this sounds like a strategy you would like to consider, contact us and one of our advisors will be happy to assist you.

© 2020