The year 2020 has created much uncertainty for many investors. The COVID-19 pandemic has resulted in a slowdown of the national economy and depending on what the new administration and the next Congress taking office in January decide, a possible increase in tax rates in the future.
It is generally not advisable for an investor to react on “what-ifs.” But during this last month of 2020, it may be a good time for federal employees to consider converting a traditional IRA they own to a Roth IRA, or for federal annuitants (or employees age 59.5 and older) transferring a portion of their traditional TSP to a Roth IRA.
This column discusses some considerations before performing a Roth IRA conversion or a traditional TSP transfer to a Roth IRA.
It is important to first discuss and explain what a Roth IRA is, and the benefits associated with Roth IRA ownership.
A Roth IRA is a type of retirement savings account that is funded with after-taxed dollars. Qualified withdrawals from a Roth IRA are tax-free. Individuals whose modified adjusted gross income (MAGI) exceed certain limits are not permitted to contribute to a Roth IRA. In particular, these MAGI limits for 2020 are $139,000 for single or head of household tax filers and $206,000 for married couples filing jointly. Another example of someone who cannot contribute to a Roth IRA for 2020 is someone who already contributed the maximum amount allowed to a traditional IRA during 2020.
Fortunately, there is a workaround for individuals who are not eligible for one reason or another to contribute to a Roth IRA. This comes in the form of a Roth IRA conversion. A Roth IRA conversion allows an individual, regardless of the amount of the individual’s gross income, to convert all or part of an existing traditional IRA to a Roth IRA. Federal employees over the age of 59.5 and federal annuitants are also permitted to transfer part of their traditional TSP account to a Roth IRA, regardless of the TSP participant’s gross income.
In order to perform a Roth IRA conversion and/or to transfer of a portion of one’s traditional TSP account to a Roth IRA, the traditional IRA owner or the traditional TSP participant has to consider several questions, including:
(1) Is the IRA owner’s or TSP participant’s marginal tax rate in 2020 lower than when the IRA owner/TSP participant will have to withdraw the money in retirement?;
(2) if the conversion and/or conversion is performed, will the traditional IRA owner/TSP participant need to withdraw the money from the Roth IRA within the next five years?;
(3) can the taxes due on conversion or transfer (both federal and state income taxes) be paid using other non-retirement account investment assets such as money held in a brokerage account, instead of taking money from the traditional TSP or traditional IRA?; and (4) does the traditional IRA owner/TSP participant have any estate gifting intentions for these assets?
While a Roth IRA conversion or traditional TSP transfer to a Roth IRA is not advantageous for everyone, there are several scenarios in which it may be to the IRA owner’s/TSP participant’s advantage.
Benefits of Roth IRA conversion/traditional TSP transfer
The potential benefits of a Roth IRA conversion/traditional TSP transfer include:
(1) Increased flexibility and tax diversification;
(2) Roth IRAs do not have required minimum distributions (RMDs) beginning when the Roth IRA owner becomes age 70.5 (if born before July 1, 1949) or age 72 (if born after June 30, 1949). Note that any converted/transferred amounts will not be included in the calculations for future traditional IRA and traditional TSP RMDs, possible lowering taxable income in the future;
(3) the traditional IRA owner/traditional TSP participant can pay taxes now at historical low levels compared to income tax rates over the past few decades; and
(4) Roth IRAs can give the Roth IRA owner increased flexibility for legacy and estate planning. In particular, higher income beneficiaries will not have to worry about mandatory Roth IRA distributions affecting their income tax liability.
Risks of a Roth IRA conversion
But there are potential risks associated with a Roth IRA conversion, including:
(1) Taxes have to be paid now. Traditional IRA owners who want to convert their traditional IRAs to Roth IRAs or traditional TSP participants who want to transfer all or a portion of their traditional TSP to a Roth IRA need to weigh the opportunity cost of using funds now to pay the taxes due versus paying taxes later if they were not converting and simply making withdrawals in the future from their traditional IRAs and traditional TSP;
(2) taxes could be lower in the future (not likely);
(3) a traditional IRA conversion or a traditional TSP transfer to a Roth IRA cannot be undone, a result of the Tax Cuts and Jobs Act of 2017; and
(4) there is not a long enough investing time horizon. Note that Roth IRA conversions need time for the earnings to grow to make up for the taxes paid – at least 5 to 10 years. If the Roth IRA owner needs the Roth IRA funds sooner than 10 years, a Roth IRA conversion may not make sense.
The following individuals may want to seriously consider a Roth IRA conversion or transfers of their traditional TSP to a Roth IRA:
· Individuals who have lower salary/wage income during 2020 due to COVID-19 or other issues. This would include those federal employees who retired during the first quarter of 2020 and therefore have less salary income in 2020 compared to previous years. However, those individuals who may lack liquid assets to pay day-to-day expenses and therefore do not have the funds to pay the taxes due on conversion should avoid a Roth IRA conversion.
· Individuals, especially annuitants in the early years of retirement, who have lower income and who are not yet taking traditional IRA and/or TSP withdrawals. These individuals and annuitants do not need IRA/TSP withdrawals to support their budget and expect low taxable income for 2020.
What Should Interested Individuals Do?
Anyone interested in performing a Roth IRA conversion and/or transfer of traditional TSP to a Roth IRA is advised to speak with a tax professional before year-end. An informed tax professional can help with the proper tax strategies. In particular, to assist with a Roth IRA conversion including calculation in determining whether it makes sense.
One particular strategy that is appropriate near year-end is to perform a partial Roth IRA conversion in order to “harvest” a specific marginal tax bracket. The three steps below explain the process involved with a “partial” conversion.
Step 1. Calculate approximate taxable income for 2020 sometime in early December. Use the following worksheet:
Itemized deductions…..Use the higher of this or the standard deduction
Standard deduction……$12,400 (single); $24,800 (married filing jointly)
Taxable income = Total income minus deductions
Step 2. Estimate additional dollars in taxable income before the next marginal tax bracket. This means given one’ year-to-date taxable income, how much additional income before is pushed into the next marginal tax bracket.
The following tables summarizes the 2020 federal marginal brackets showing the taxable income limits:
Step 3. Consider a Roth IRA conversion or a traditional TSP transfer to a Roth IRA for an amount up to the next tax bracket.
A partial Roth IRA conversion or a traditional TSP transfer to Roth IRA up to a specific tax bracket can be more beneficial versus a full conversion or a full traditional TSP transfer. By targeting a specific tax bracket, the IRA owner or traditional TSP participant can limit his or her current year tax return and lock in that tax rate for the converted amounts. For example, if a traditional IRA is converted to a Roth IRA and the IRA owner is in a 22 percent marginal tax bracket, then the Roth IRA will benefit (in the form of lower overall taxes) if the IRA owner’s tax rate in the future is over 22 percent. By targeting a specific tax bracket an IRA owner or TSP participant can also potentially reduce the amount of time to recoup the taxes paid on the conversion/transfer.
For example, if one is married filing jointly and anticipates $148,000 in taxable income in 2020 (thus being in a 22 percent marginal income tax bracket, then the individual can (see step 2) convert up to $24,050 ($171,050 less $148,000) of a traditional IRA to a Roth IRA (or transfer up to $24,050 of the traditional TSP to a Roth IRA)and pay taxes at the 22 percent tax rate on that amount before moving into the next higher (24 percent) tax bracket.
Besides the marginal tax brackets that IRA owners/traditional TSP participants need to consider before performing a Roth IRA conversion or a traditional TSP transfer to a Roth IRA how the additional income may affect the IRA owner/traditional TSP participant’s state income tax liability if any, as well as other potential IRS surtaxes including the net investment income (NII) surtax of 3.8 percent. The NII surtax applies to the lesser of unearned income or modified adjusted gross income (MAGI) over a base amount. The base amounts are summarized in the following table. Note that converted Roth IRA amounts are included in MAGI in the yar of conversion or transfer to a Roth IRA.
MAGI Threshold for Net Investment Income Surtax after December 31, 2012*
Once again, any individual interested in performing a Roth IRA conversion or a transfer of a portion of a traditional TSP account at this time of year is strongly encouraged to first speak with a tax professional.