In response to the COVID-19 pandemic, the CARES Act was signed into law March of this year. One of the Act’s major provisions was the suspension of Required Minimum Distributions (RMDs) for the 2020 tax year from certain retirement accounts – specifically, defined contribution plans and IRAs. This suspension allows IRA owners to avoid taking RMDs this year to help IRAs (or other retirement accounts) recover values lost due to the adverse market conditions caused by the current pandemic. The waiver of RMDs this year also provides an opportunity for IRA owners to convert a portion of their traditional IRA to a Roth IRA while incurring less taxes than would be the case in other years.

During years when RMDs are required, you must first withdraw your RMD amount before making any conversion of a traditional IRA to a Roth IRA. The Roth conversion needs to be carefully planned, since it results in additional income taxes and could potentially place an individual in a higher income tax bracket. Let’s illustrate this with an example. John (age 75), in a year which RMDs are required, wants to convert $20,000 to a Roth IRA. His normal annual RMD amount is $50,000, so John would need to first take his $50,000 RMD, and then take an additional $20,000 in order to do the conversion. This would result in a total taxable income of $70,000. Due to this requirement, individuals in RMD status will likely not undergo a Roth conversion due to the resulting income taxes.

The suspension of RMDs provides a unique opportunity to do a Roth conversion. Revisiting our prior example, John can now convert $20,000 of his traditional IRA to a Roth IRA without having to take his normal annual $50,000 RMD amount, since they are suspended this year. John would only incur taxes on the amount converted ($20,000). Why would John do a conversion and incur taxes when he can avoid taking distributions all together this year? Doing a conversion when retirement account values are down could lessen the tax impact of the conversion. John’s conviction regarding a Roth conversion will also depend on his thoughts of where taxes are heading. If he believes strongly that taxes will go up, which could occur given the amount of stimulus recently paid out and the fact that it is an election year, doing a conversion this year could make sense. Also, if John has the funds to pay the tax resulting from the conversion outside of the IRA or retirement account, the conversion acts as a possible substantial additional contribution. This will then allow him to establish a tax-free account (Roth) while incurring income taxes that would be less than in years when RMDs are required.

Additional Planning Notes:

• IRAs inherited from a non-spouse (IRAs which you are not an owner of) are not eligible for a Roth conversion, and any amounts withdrawn from it cannot be rolled into a tax favored retirement plan.
• RMDs are only suspended for Defined Contribution Plans (e.g., 401(k) and 403(b) plans) and IRAs, and do not extend to Defined Benefit Plans (e.g., pension plans).

If you would like to learn more about how the CARES Act impacts individuals, please see our resource here.

Every situation is unique and may result in different tax and financial planning considerations. If you are interested in this strategy or have any questions regarding the CARES Act, please contact your wealth advisor.