“In the middle of difficulty lies opportunity” - Albert Einstein
As financial planners, it’s our job to uncover the financial opportunities of any situation and apply them to our clients. One such opportunity unique to the COVID-19 crisis centers around ROTH conversions. Not in what they are – they have been around for years – but in how you do them. The CARES Act has changed the game when it comes to ROTH conversions.
Benefits of ROTH IRA’s
Having a tax-free ROTH bucket in retirement is coveted. But, having significant money in a ROTH is difficult for high income earners to achieve. That is because there are yearly contribution limits and you may not even be allowed to contribute at all if your income is too high. Enter: The ROTH Conversion. There is neither an income restriction limit on who may convert nor is there a cap on the amount converted. And, the CARES Act changes the cost-benefit analysis drastically – in your favor. ROTH Conversions are a fantastic way to get money into a tax-free bucket, especially for those having large amounts of assets in pre-tax plans and/or those who otherwise are not allowed to contribute to ROTH IRA’s due to income restrictions.
What is a ROTH IRA?
ROTH IRA’s are a retirement account like a Traditional IRA or 401k (so-called pre-tax plans). They are for contributions meant for retirement and penalties may be owed if funds are withdrawn before age 59.5. However, there are some very notable differences. First, contributions to a ROTH are not tax deductible like they are for pre-tax plans[1]. Second, your contributions and your gains grow tax-free since you do not owe taxes on qualified ROTH withdrawals[2]. Lastly, you are not forced to make Required Minimum Distributions (RMD’s), or withdraw money beginning at the age of 72, as you are in pre-tax plans[1]. The tax-free treatment of qualified distributions and lack of RMD’s make ROTH’s a compelling option for your long-term money.
What is a ROTH Conversion?
Technically, a ROTH conversion is the act of converting funds in a pre-tax retirement plan, like a 401k or Traditional IRA, to a ROTH IRA. This is done by taking a distribution from the pre-tax plan and making a subsequent contribution into the ROTH. The assets contributed into the ROTH must be the same as the assets you have distributed from your pre-tax plan, and the deposit must be completed within 60-days of the distribution[1]. Often, your brokerage firm can handle this seamlessly using a ROTH conversion form if both accounts are custodied with them. The 10% penalty for IRA withdrawals taken before age 59.5 is waived for a conversion but you will have to declare the withdrawn amount as income on your tax return[1].
CARES Act Provisions
Only for 2020, the CARES Act changes a major component of the ROTH conversion process: How taxes are calculated on the conversion. You do have to qualify for this provision by being negatively impacted by the COVID-19 crisis. Qualifications include you or your dependent contracting the virus or having suffered adverse financial impacts from being quarantined, being furloughed or laid off, or having wages or hours reduced[3]. The law states that taxes owed on 2020 IRA distributions up to $100k can be spaced out over the next 3 years[3]. So, if your annual income is $100k and you take a $100k IRA distribution in 2020, you can pay taxes on income of $133.34k/year over the next three years. That is a great benefit considering that normally you would have been taxed on $200k worth of income in one year.
Pay Taxes Owed Over 5-Years
Another benefit of the CARES Act is regarding 401k loans taken within 180-days of the act being passed. The loan limits have been increased to $100k or 100% of your vested balance, as compared to a maximum of $50k or 50% of your vested balance absent the legislation. Additionally, the loan payments can be deferred for up to one year[3]. However, interest still accrues, and the 5-year repayment deadline still pertains. 401k loan proceeds are non-taxable if you remain with that employer. And, interest paid on these 5-year loans goes back to you – via your 401k account. The downside is that if you cease employment with that employer, the balance of the loan would be taxed as income plus a 10% penalty if not repaid. And, you must be able to afford the loan payments. However, if you can afford the payments and are willing to take the employment risk, spreading your taxes on your ROTH conversion over 5-years via a 401k loan might make sense.
Should You Take a 401k loan?
Most financial planners do not advocate taking loans from your 401k. And for good reason. This is your retirement money. You can get a loan for many things, but you cannot get one for retirement. Borrowing against your 401k could take much needed money away from your retirement years. Most calculations use a rate of return, say 6%, to illustrate the opportunity cost of taking money out of your plan today. The notion goes if you take $30k out and it would have been earning 6% per year compounded, you are taking much more than $30k from your retirement. Sound advice, for sure. But, consider this. Unless you are uber aggressive, it is likely you have bond investments in your 401k. Those bonds are not likely to earn 6% compounded for the next 5-years, especially given the current state of interest rates. If you borrow from the bond portion of your 401k, and you re-pay the loan with interest over 5-years, aren’t you acting as a 5-year bond in your portfolio? If you have enough money in the bond portion of your portfolio to cover your ROTH conversion taxes, you may consider borrowing it to pay them. You must pay those taxes, anyway, from some account. Might as well keep that money in its account and use the 401k bond portfolio money to pay the taxes. Worst case, you cease employment and you must re-pay the remaining loan balance using money in another account. The same money you would have used to pay the taxes in the first place.
This COVID Crisis has brought us much difficulty but converting pre-tax dollars to a ROTH and spreading the taxes owed over the next 3-years is not one of them. Especially when you can borrow from your 401k to pay the taxes and repay yourself principal and interest over 5-years.
Notes
1. Source: IRS Publication 590-A
2. Subject to IRS qualifications
3. Source: Cornavirus Aid, Relief, and Economic Security Act (CARES Act) H.R 748-2 Subtitle B- Rebates and Other Individual Provisions