If you’ve thought about buying real estate in a self-directed Roth IRA but would like to get more money into that account, 2020 may be the year to do a Roth IRA conversion from a traditional IRA or 401k. The conversion will trigger a tax event, but due to current circumstances, you might save a bundle of money doing that conversion this year.
Whether you have a self-directed Roth IRA for alternative investments, like real estate, or a Roth IRA at a brokerage for stock investing, the benefits of a Roth account are very attractive. You fund a Roth account with after-tax money so you don’t get a tax break right away, but any distribution you take later in life is completely tax free. You don’t pay capital gains tax for any IRA account, and for Roth, you don’t pay any income tax when you withdraw your funds.
Unlike the Roth, contributions to a traditional IRA are made with pre-tax money. That lowers your taxable income for the year of the contribution, but years later, when you pull that money out, Uncle Sam will charge you income tax. If you are retired, you may have a lower tax bracket which will reduce the amount of income tax you pay on distributions. But, if you invested wisely and have more money in the account, you will end up paying income tax on a much larger account balance.
The 2020 Roth IRA Conversion
So why should you think about converting in 2020?
Tax rates are very low right now thanks to the Tax Cuts and Jobs Act. Some financial experts say they may be the lowest we’ll ever see in our lives. As it stands now, they are only in effect until the year 2026. So they should stay where they are for another few years, but it’s possible they’ll go up sooner. That will depend on the political climate, and the need to address a massive amount of government debt because of all the coronavirus stimulus programs. But they are low right now. (1)
Another reason to consider a conversion in 2020 — Your tax bracket may be lower because of a smaller paycheck. A lot of people have taken a financial hit from the pandemic. If you fall into that category, you will have a lower tax bracket and will pay less to convert funds from a traditional IRA to a Roth IRA. Be mindful of how much you convert so you don’t push your 2020 income into a higher tax bracket.
Another thing to consider is the value of your account. Your traditional IRA may have suffered losses during the pandemic which means less money to convert. Losses are never a good thing, but converting during a downturn could put money into a Roth account where you could benefit from the next economic upturn, tax free.
A Few Roth IRA Rules
It’s important to note that the 10% penalty for withdrawing money out of your retirement account before age 59-and-a-half has been waived for the year, as part of the CARES Act. It’s also important to note that any new Roth account has a five-year waiting period before you can withdraw money tax free, even if you are 59-and-a-half. As BankRate explains, “The 5-year rule for Roth IRA distributions stipulates that 5 years must have passed since the tax year of your first Roth IRA contribution before you can withdraw the earnings in the account tax-free.”
There has been some discussion as to whether you can take a penalty-free coronavirus distribution from your traditional retirement account, and do a Roth conversion when you pay it back. People impacted by the coronavirus for one of several qualified reasons are allowed to take as much as $100,000 from a retirement account, and pay it back over three years. Some people have questioned whether this could be used to convert Roth funds over a three-year period which would reduce the tax burden in any given year. According to a Forbes article, the repayment of a coronavirus distribution must be a tax-free event, and a Roth conversion is not. Taking money out of your retirement account for the sake of a Roth conversion would also not qualify as a pandemic-related hardship. (2)
But don’t let that discourage you from considering a Roth IRA conversion. You’re only allowed to put $6,000 a year into a Roth, or $7,000 if you’re age 50 or older, so this is a great way to boost your account balance. I also encourage you to check into the benefits of a self-directed Roth IRA, which allows you to invest in real estate. There are plenty of rules, but the benefits are worth the effort. You’ll find information on self-directing your IRA at our website in the Learning Center.
(2) Forbes Article