The last few months have inundated us with programs and legislation designed to help us regain our financial stability. It can be overwhelming, even for a professional financial advisor. One of the attempts to help, the CARES Act, similar to what was done in 2010 following the Great Recession, allows retirees subject to required minimum distributions (RMDs) from their IRAs to skip those distributions in 2020.
This is generally seen as an attractive option for two reasons: Skipping will lower taxable income for the year and investments in IRAs depressed by the market correction in the first quarter of 2020 have more time to recover.
But a short-term win could generate a long-term loss. The Tax Cuts and Jobs Act (TCJA) of 2018 have given us some of the most favorable tax rates in many years. These rates are currently scheduled to sunset in 2026 and return to the 2017 schedule. Skipping 2020 RMDs will give you a larger IRA balance that, given the tax rates upon the sunsetting of TCJA, will generate a 2026 tax bill that outweighs the advantage of taking the RMDs in 2020 and paying at the lower rate.
For example: A married couple in 2019 with an adjusted gross income (AGI) of $200,000 and a $90,000 RMD had a marginal tax rate of 24 percent. In 2020 without the RMD, their AGI of $110,000 places them in the 22 percent tax bracket—a 2 percent change. Let’s assume a 2026 AGI of $250,000 in which $130,000 is RMD. With the reversion to 2017 tax rates, their marginal tax rate would be 33 percent—a more than 37 percent increase in their tax rate.
So, do they take their RMDs this year? There is another option. Before the CARES Act, people in their RMD years couldn’t do Roth conversions in a particular year until after completing their RMDs. That makes converting less attractive as the dollars will be taxed as additional income, and therefore at the retiree’s premium rate. But with no RMD due in 2020, an individual in their RMD years can now convert any amount they wish to a Roth. Compound that option with the depressed values of some asset classes and a Roth conversion of an out-of-favor asset can provide some very attractive long-term tax-free appreciation.
Instead of skipping their 2020 RMD, the couple uses that same $100,000 ($90,000 in 2019 plus growth and increases due to decreased life expectancy) as a Roth conversion. They make an in-kind transfer of a depressed asset to the Roth. They pay the tax they had expected for 2020, but now they have a depressed asset growing tax-free as long as it remains in the Roth. The tactic serves to keep future RMDs as previously budgeted while taking advantage of the current low tax rates.
Now consider the strategy in light of another of the year’s new laws, the SECURE Act. Prior to the SECURE Act, an adult child inheriting their parents’ IRA had the option of spreading the taxable income over their lifetime. With the passing of the SECURE Act those accounts must be depleted within 10 years, making the IRS a beneficiary of the IRA as these new income dollars are taxed when the beneficiaries’ are in their highest earning years and their highest income tax brackets. The Roth conversion strategy leaves a tax-free asset to the beneficiary. As well, consider “micro” Roth conversions, converting smaller amounts each year to continuously reduce future potential taxes and grow the tax-free asset to be left to your beneficiaries.
While skipping your RMDs in 2020 seems a perfectly sound move on the surface, IRA holders should consider how that plays out over the years, in particular for each year between now and 2026 when the TCJA cuts sunset.
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