Amid the pain and suffering of the coronavirus pandemic, workers saving for retirement can take comfort in one silver lining. And it's a big one: The coronavirus stock market crash makes Roth IRA conversions extremely attractive.
First a caution: Don't fall for unfounded "advice" on Roth IRA conversions. One trick you'll see pitched involves stretching tax payments on the conversion amount out over three years. The IRS has not given this move a thumbs-up, contrary to what you might read. The tax agency could drop a costly hammer on taxpayers attempting this maneuver. We'll look at this later in this report.
Coronavirus Pandemic: Silver Lining
But first, let's look at the genuine silver lining to the coronavirus pandemic: legit Roth IRA conversions.
Roth conversions have always been a good idea for workers who expect their income tax rate and bracket to rise in retirement, says Ed Slott, founder of IRAHelp.com. If tax rates rise in the future to cover the coronavirus bailout, today's tax rates would be low enough to be worth locking in now.
And Slott does anticipate widespread tax-rate hikes. "I don't think tax rates will ever go lower than they are now," he said. "Look, taxes will have to increase now that the government just wrote a $2 trillion check on a bank account with no money in it. At some point, that bill comes due."
The $2 trillion check is the size of the economic stimulus package that President Donald Trump signed into law on March 27 to deal with the U.S. impact of the coronavirus pandemic. Slott's allusion to an empty bank account refers to the federal debt, which was $22.8 trillion as of Dec. 31.
In addition, the coronavirus stock market crash has made Roth conversions even more attractive by slashing the prices of stocks and stock mutual funds.
Has The Coronavirus Pandemic Created Investment Opportunities?
The good news: Those declines in value due to the coronavirus pandemic mean the income tax that you'd pay on any traditional IRA (all of it or part of it) that you convert to a Roth IRA is much lower now than it would have been before the onset of the coronavirus stock market correction.
Remember, taxes are triggered when you make a Roth conversion. Assets or money that you shift from a traditional IRA into a Roth become taxable. It's as if you took it out in a plain withdrawal, without putting it back into a Roth IRA.
So if converting investments from a traditional IRA into a Roth IRA means that you get walloped by an income tax bill, why does anyone bother doing a Roth conversion? After all, why voluntarily subject yourself to paying tax years before you'd have to otherwise?
"The reason is that a Roth conversion entitles you to tax-free withdrawals from your Roth IRA forever, once you've held the account five years and reach age 59-1/2," Slott said. "And forever is a very long time."
How The IRS Treats Roth IRAs And Roth Conversions
Better yet, the IRS treats all of your Roth IRAs as one account. Suppose you are 60 years old. Let's say you open a Roth IRA to receive mutual fund shares from a traditional IRA in a conversion. If you opened any other Roth IRA more than five years ago, the IRS treats your new Roth IRA as if it too is more than five years old.
But if you are younger than 59-1/2, you must hold the new conversion Roth IRA itself for at least five years for withdrawals of the conversion amount to be penalty-free. You'll also be allowed to take out any earnings penalty-free after five years and once you are 59-1/2 years of age or older.
You instantly become eligible for tax-free withdrawals at any time from the new Roth IRA.
That's the silver lining inside the coronavirus pandemic's dark cloud.
What Is A Roth Conversion Worth Amid The Coronavirus Pandemic?
How much do you stand to benefit from a Roth conversion amid the coronavirus pandemic? Going into Monday, the broad market in the form of the S&P 500 was still down 17% from its Feb. 19 peak before the start of the coronavirus stock market correction.
Suppose your traditional IRA was worth $100,000 on Jan. 1. If its value crashed along with the market, it's now worth 17% less or just $83,000. Taxes on a conversion are based on the account's value at the time of the conversion. That means if you converted the traditional IRA Monday to a Roth IRA, you'd pay tax on the current $83,000 value, not the much higher $100,000 at the start of the year.
One Reason To Be Wary Of A Roth Conversion
But just as there is no such thing as a free lunch, there is no such thing as a risk-free investment move.
The first risk to beware of is that you are no longer allowed to do what was known as a recharacterization of a Roth IRA conversion. That maneuver, undoing a Roth conversion, was banned by the Tax Cuts and Jobs Act of 2017 (TCJA).
Under the old law, you could recharacterize a Roth IRA conversion from a traditional IRA for any given tax year if you did it by the following Oct. 15. People typically re-characterized a Roth conversion if a stock market dip after the conversion meant they'd be paying income tax based on a much higher value for the assets than they were worth once the market declined.
Investors often re-characterized with the intention of converting again later on, so their income tax will be lower, based on the post-decline valuation.
Remember To Play By The New Rules Governing Roth Conversions
Another reason for recharacterizing was if a taxpayer realized later that he could not afford to pay tax on the conversion.
"Now that you can't go backwards, make sure that you can afford the tax on a Roth conversion before doing it," Slott said.
One solution: Wait until December to do a conversion, Slott says. By then, you should have a clearer idea of your income for the year and whether you can afford the tax on the conversion.
But remember, if you wait until December, the market may rebound. You'd lose your opportunity to convert while the coronavirus pandemic depresses the market and your tax bill.
Can You Afford A Roth Conversion?
The second risk to beware of is some potentially bogus advice making the rounds on the web.
The economic stimulus package has loosened the limits on hardship withdrawals from traditional IRAs and 401(k)s. If you've been hurt by the coronavirus pandemic — let's say by catching the disease or losing your job — you can withdraw up to $100,000 from your retirement account without penalty. Normally, you'd pay a penalty if you're younger than 59-1/2.
The stimulus bill lets people pay the tax due on that withdrawal over three years, not all at once with that year's tax return, as in normal times.
But some online pundits are taking that new freedom a step further. They say you can contribute that withdrawal to a Roth IRA.
"That's a potentially bogus creative strategy for stretching the tax out over three years," Slott said. "In the stimulus bill, Congress did not say people can do that. If the IRS rules that it's OK, so be it. But neither the IRS nor Congress has said that yet. And you could find yourself in hot water by trying that now."
Follow Paul Katzeff on Twitter at @IBD_PKatzeff for tips about personal finance and strategies of the best mutual funds.
