Editor’s note: Since this article was published, the IRS has expanded certain provisions in the CARES Act. Please see CARES Act updates: More investors qualify for relief for details on these changes.
As a wealth planner, I’m sensitive to how investors react in a volatile market. It’s hard to keep perspective in the middle of a crisis, especially when there are so many unknowns.
At the same time, the current situation has created several potential tax-planning opportunities. The down market, the passage of the CARES Act (Coronavirus Aid, Relief, and Economic Security) in March 2020, and the establishment of the SECURE Act (Setting Every Community Up for Retirement Enhancement) in December 2019 present several ways for investors to manage their taxes now and in the future.
1. Skip RMDs for 2020
Strategy: Take advantage of a CARES Act provision allowing you to avoid taking required minimum distributions (RMDs) for 2020. If you took RMDs in 2020, you can roll back these amounts by August 31.
How to do it: If you’re scheduled to take your distribution automatically through our RMD Service, you can cancel any remaining distributions for 2020 at vanguard.com by following these steps:
- Log on to your account.
- From the menu, choose My Accounts and select Retirement contributions, distributions & RMDs.
- Under Retirement summary, choose Required minimum distribution.
- Depending on your account type, select either Change RMD service option or Delete.
- If you chose Change RMD service option, select the Calculation only method on the next page. Or if you chose Delete, just choose Submit on the next page.
- Reactivate your RMD in 2021.*
Who may benefit: Anyone subject to RMDs (who doesn’t rely on the distribution for income). This includes:
- Individuals who turned 70½ before 2020, or
- Heirs of an inherited IRA/Roth or retirement plan account subject to RMDs.
If you turned 70½ last year and delayed your first distribution to April 1, 2020, you were required to take 2 distributions this year, but now you can waive both withdrawals.
Details: The CARES Act includes a 2020 RMD waiver, an important provision to many investors who have seen their retirement account values dip significantly compared with December 2019, when 2020 RMDs were calculated. Taking distributions during a down market could mean locking in those market losses.
New retirees are often surprised at the tax implications of RMDs, which can affect taxes on benefits like Social Security and Medicare parts B & D premiums. The CARES Act provides relief, at least in the short term. It also presents an opportunity to keep your assets invested in the market so your portfolio has the opportunity to benefit from a recovery.
Potential risks: If you can afford to waive your RMDs, there’s little downside. Of course, leaving your money invested instead of taking distributions carries normal market risks.
2. Invest in a Roth IRA (if you qualify) in 2019 and 2020
Strategy: Choose a Roth IRA over a traditional IRA, if you qualify. Take advantage of low tax rates and the extended deadline for 2019 contributions, which is now July 15, 2020.
Who may benefit: Investors with earned income who are eligible to contribute to a Roth IRA.
To contribute the maximum amount ($6,000; $7,000 if you’re 50 and older), individuals must have a modified adjusted gross income (AGI) of less than $139,000. Couples qualify with a modified AGI of less than $206,000.
In 2020, your income might be lower due to layoffs and furloughs related to the COVID-19 outbreak. It’s not always realistic to think about investing for the future in the midst of a global crisis. However, some investors who don’t qualify under normal circumstances may be able to take advantage of the opportunity to invest in a Roth.
Details: If you’re trying to decide between a Roth vs. a traditional IRA, think about whether it makes more sense for you to pay taxes now (Roth) vs. later (traditional). If you anticipate earning more and paying higher income taxes in the future, you may want to consider a Roth.
Many people will face higher taxes after the TCJA of 2018 (Tax Cuts and Jobs Act) sunsets at the end of 2025. In addition, the SECURE Act changed stretch IRA rules for many non-spouse beneficiaries to a 10-year payout. The result: Your income taxes will likely be lower in 2020 than your own and your heirs’ income tax rates in the future.
Keep in mind that a Roth IRA offers more flexibility than a traditional IRA does. Withdrawals of contributions are tax- and penalty-free anytime—you don’t have to wait until you’re age 59½. To withdraw income-tax-free earnings, you must wait until you’ve reached age 59½ and have held the account for at least 5 years.
Potential risks: A Roth is a flexible retirement account. However, since future tax laws can always change, I recommend diversifying your portfolio with a mix of tax-deferred and Roth accounts in addition to taxable accounts.
3. Convert your traditional IRA to a Roth IRA
Strategy: Convert a traditional IRA to a Roth IRA to take advantage of lower income and lower taxes in 2020.
Who may benefit: Individuals invested in a traditional IRA, including retirees who don’t have to take an RMD in 2020 due to the CARES Act, as well as investors who are still working and earning income above the Roth threshold.
Details: When you convert a traditional IRA to a Roth IRA, you’re taking a distribution from a traditional IRA, paying taxes at your ordinary income rate, and then opening a Roth IRA with the remainder. When you do a conversion, you’re not subject to an early withdrawal penalty, even if you’re under age 59½.
This type of conversion is most beneficial to investors who could face high RMDs in the future—Roth IRAs (with the exception of inherited Roth IRAs**) aren’t subject to RMDs. Converting to a Roth can also help you gain tax diversification, since you don’t have to pay taxes on Roth earnings when you withdraw them in retirement.
Potential risks: There’s a chance you could end up paying more taxes now than you would have if you’d left the money in a traditional IRA.
You may want to consider the following factors:
- Timing. Current market volatility makes it nearly impossible to know the best time to convert, but now may be a good time if your retirement account values are down. Many investors stagger multiple conversions throughout the year.
- Legacy planning. Take into account your heirs’ income tax situations—under the SECURE Act, they may be subject to higher income taxes than you are. Income taxes paid on a Roth conversion can be considered “additional gifts” made to your heirs, and the taxes you pay reduce the gross amount of your estate, which could increase the wealth you pass on to your heirs. Consult a qualified tax advisor about your personal situation.
- Commitment. In the past, you could undo a Roth conversion—also known as recharacterization—through the extended due date of your tax returns. That’s no longer the case. Once you convert a traditional IRA to a Roth IRA, you can’t reverse it.
Keep things in perspective
I’m in the glass-half-full camp who believes volatility is temporary, and the markets will recover eventually. In the meantime, I’m looking for investment opportunities in the current market, using the information I have, to make the best of a challenging situation.
*If you cancel an automatic distribution this year, you’ll have to reactivate it in 2021 to help ensure you take your full RMD for next year. Ordinarily, there can be a 50% federal penalty tax on any RMD amount that’s not distributed. If you’d like to cancel your RMDs this year but automatically restart them in 2021, call us at 800-662-2739 on business days from 8 a.m. to 8 p.m., Eastern time. We’d be happy to help you or answer any questions you may have.
**Under the SECURE Act, heirs generally have 10 years to deplete their inherited retirement plans, including Roth IRAs.
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.
- Withdrawals from a Roth IRA are tax-free if you’re over age 59½ and have held the account for at least 5 years; withdrawals taken prior to age 59½ or 5 years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate 5-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).
- We recommend that you consult a tax or financial advisor about your individual situation.