2020 will be a year to remember for decades to come. In the world of tax and retirement planning, it’s brought opportunities for advisors to present to clients. But unlike those in other years, 2020’s opportunities should be seized now—taken advantage of before year’s end—because they may not be as effective afterward.
Here are the five best ideas for advisors to share with clients before 2020 ends:
1. 2020 Roth Conversions
Yes, these are always on the year-end, to-do list, but this year the tax benefits may be the highest ever because of historically low tax rates and possibly lower income for many due to the Covid-19 pandemic.
However, be warned. Today’s low rates will not last. The rates were already set to snap back to pre-2018 levels after 2025, but they could go higher as soon as next year. The Congressional Budget Office has reported that as of the end of fiscal 2020 (which ends on September 30, 2020) the U.S. budget deficit will reach $3.3 trillion, a level not seen since the end of World War II. Trillions more in stimulus spending may be in the works (or already done by the time you read this). According to the CBO, the national debt will exceed $20.3 trillion by the end of September 2020. To put this in perspective, that is set to exceed our total annual economic output, and this year’s deficit levels are more than triple those of 2019.
And it’s getting worse each day. On September 3, 2020, The Wall Street Journal said, “One way or another, we’ll be paying this off for the rest of our lives.” The paper added “there’s no such thing as free borrowing. Even the U.S. with all its economic power can’t keep piling up debt forever.” In other words, the bill will come due, and that bill will end up being paid mainly with tax increases. Those tax increases may come as early as 2021, no matter who is elected president.
That puts tax-deferred retirement savings in jeopardy. In essence, tax-deferred accounts like traditional IRAs include a debt that will have to be paid to the IRS at some point. It’s up to advisors to help clients pay that debt off at the lowest possible tax rates, and that may well be right now. That’s why advisors should be looking more seriously at Roth conversions now, before year’s end.
Advisors should contact every client with traditional IRAs and evaluate a 2020 Roth conversion. They should also communicate with the clients’ CPAs or other tax advisors to project the tax cost of a 2020 Roth conversion. It may be that for most clients the best strategy is to do a series of smaller annual conversions over time, using up the lower tax brackets each year while they last. You should also make sure that there are funds available to pay the tax, because once a Roth conversion is done, it is permanent. The tax will be owed. The Tax Cuts and Jobs Act of 2017 eliminated recharacterizations of Roth conversions beginning in 2018.
As 2020 winds down, this is the optimum time to project the tax cost of a conversion because most people by this time will have a reliable estimate of their 2020 income. And they may be able to convert larger amounts with a lower tax bite if the pandemic caused them business losses or unemployment. Remember, though, that unemployment insurance is taxable income, and many people received these increased payments.
Once funds are converted, today’s low tax rates are locked in, plus the funds in the Roth grow income tax free forever and Roth IRAs have no lifetime required minimum distributions (RMDs). Any IRA funds converted will lower these tax-deferred IRA balances and in turn lower the amount of future RMDs that could be exposed to higher taxes.
Some clients may think they will be in a lower tax bracket in retirement, but that doesn’t often happen, especially after a spouse dies and the surviving spouse sees their tax bills increase when they begin to file as single.
The bottom line here is that a Roth conversion removes the risk and uncertainty of what future higher tax rates can do to a client’s retirement income.
The best part of the Roth conversion is what it does in the worst-case scenario. Even if it turns out taxes do not increase (which is unlikely) or that maybe taxes go even lower for some clients (even more unlikely), the tax rate on Roth distributions in retirement will be zero. That is not a bad worst-case scenario.
Though Roth conversions will still be available in the future, advisors should still consider doing them in 2020 (to count, the funds must leave the IRA or company plan before year’s end).