As a wealth planner, I am sensitive to how investors react in a volatile market. It is difficult 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 downward market, the adoption of the CARES law (Coronavirus Aid, Relief and Economic Security) in March 2020 and the introduction of the SECURE Act (setting up every community to improve retirement) in December 2019 offer investors different ways to manage their taxes now and in the future.
1. Skip RMDs for 2020
Strategy: Use a CARES Act provision that you can use to avoid making the required minimum distributions (RMDs) for 2020. If you took RMDs on or after February 1, 2020, you can reset these amounts until July 15. Note that distributions from IRAs are rolled back every 365 days. In addition, the rollback option is not available if the plan is inherited.
How it goes: If you want to automatically process your distribution using our RMD service, you can cancel it remaining Distributions for 2020 at vanguard.com as follows:
- Log in to your account.
- Choose from the menu My accounts and select Pension contributions, distributions & RMDs.
- Under Summary of retirement, choose Minimum distribution required.
- Depending on your account type, choose one of the two options Change the RMD service option or Clear.
- If you want Change the RMD service option, choose Calculation only Method on the next page. Or if you want Clear, Just choose Submit on the next page.
- Reactivate your RMD in 2021. *
Who can benefit from it: Anyone who is subject to RMDs (who doesn’t rely on income distribution). This contains:
- People who were 70½ years old before 2020, or
- Heirs to an inherited IRA / Roth or pension plan account that is subject to RMDs.
If you turned 70½ last year and postponed your first payout to April 1, 2020, you had to make two payouts this year, but you can now do without both payouts.
Details: The CARES law includes a repeal of the RMD for 2020, an important provision for many investors whose pension account value has dropped significantly compared to December 2019 when the RMD was calculated for 2020. Distributions during a down market could offset these market losses.
New retirees are often surprised at the tax implications of RMDs, which can affect taxes on benefits such as social security and Medicare parts B & D premiums. The CARES law offers relief at least in the short term. It also offers the ability to keep your assets in the market so your portfolio can benefit from a recovery.
Possible risks: If you can afford to do without your RMDs, there are few disadvantages. Of course, it is normal market risk if you leave your money invested instead of making distributions.
2.Invest in a Roth IRA in 2019 and 2020 (if you qualify)
Strategy: Choose a Roth IRA over a traditional IRA if you qualify. Take advantage of the low tax rates and the extended deadline for contributions for 2019, which is now July 15, 2020.
Who can benefit from it: Investors with earned income who are eligible to contribute to a Roth IRA.
To contribute the maximum amount ($ 6,000; $ 7,000 if you are 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 could be lower due to layoffs and vacations related to the COVID 19 outbreak. It is not always realistic to think about investing in the future in the midst of a global crisis. However, some investors who do not qualify under normal circumstances may take the opportunity to invest in a Roth.
Details: When trying to choose between a Roth and a traditional IRA, consider whether it makes more sense for you to pay taxes now (Roth) or later (traditionally). If you want to earn more and pay higher income taxes in the future, consider a Roth.
Many people will face higher taxes after the TCJA’s sunset in 2018 (Tax Cuts and Jobs Act) in late 2025. In addition, the SECURE Act has changed the IRA rules for many non-spouse beneficiaries to a 10-year payment. The result: Your income taxes are expected to be lower in 2020 than your own and your heirs’ income tax rates in the future.
Note that a Roth IRA offers more flexibility than a conventional IRA. Withdrawals from contributions are tax and penalty free at all times – you don’t have to wait until you are 59½ years old. To withdraw income tax-free income, you must wait until you are 59½ years old and have held the account for at least 5 years.
Possible risks: A Roth is a flexible retirement account. However, since future tax laws can change at any time, I recommend diversifying your portfolio in addition to taxable accounts with a mix of deferred taxes and Roth accounts.
3. Convert your traditional IRA to a Roth IRA
Strategy: Convert a traditional IRA to a Roth IRA to benefit from lower income and lower taxes in 2020.
Who can benefit from it: Individuals who have invested in a traditional IRA, including retirees who do not need an RMD due to the CARES law in 2020, and investors who are still working and earning income above the Roth threshold.
Details: When you convert a traditional IRA to a Roth IRA, you take a payout from a traditional IRA, pay taxes at your normal income rate, and then open a Roth IRA with the rest. If you do a conversion, you are Not subject to an early payment penalty, even if you are under 59½ years old.
This type of conversion is most advantageous for investors who may face high RMDs in the future – Roth IRAs (with the exception of inherited Roth IRAs **) are not subject to RMDs. Switching to a Roth can also help you achieve tax diversification, as you don’t have to pay taxes on Roth income when you retire.
Possible risks: There is a possibility that you are now paying more taxes than if you left the money in a traditional IRA.
You may want to consider the following factors:
- Timed coordination. Due to the current market volatility, it is almost impossible to determine the best time for the switch. However, now can be a good time if your retirement account values have dropped. Many investors do 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. Income taxes paid on a Roth conversion can be viewed as “additional gifts” to your heirs. The taxes you pay reduce the gross amount of your estate, which can increase the wealth that you pass on to your heirs. Ask a qualified tax advisor about your personal situation.
- Engagement. In the past, you could undo a Roth conversion – also known as Re-characterization– by the extended due date of your tax return. That is no longer the case. Once you’ve converted a traditional IRA to a Roth IRA, you can’t undo it.
Keep the perspective
I am in the half full warehouse and I think volatility is temporary and the markets will recover at some point. In the meantime, I am looking for investment opportunities in the current market and am using the information I have to get the most out of a challenging situation.
* If you cancel an automatic distribution this year, you’ll need to re-enable it in 2021 to ensure you get your full RMD for the next year. A penalty tax of 50% can normally be levied on any undistributed RMD amount. If you’d like to cancel your RMDs this year but want them to restart automatically in 2021, call us on 800-662-2739 on weekdays from 8:00 a.m. to 8:00 p.m. Eastern Time. We are happy to help you or answer your questions.
** According to the SECURE Act, heirs typically have 10 years to exhaust their inherited pension plans, including the Roth IRAs.
- Every investment is subject to risk, including the possible loss of the money you invest.
- Diversification neither secures a profit nor protects it from a loss.
- Withdrawals from a Roth IRA are tax free if you are over 59½ years old and have held the account for at least 5 years. Withdrawals before the age of 59½ or 5 years may be subject to normal income tax or a 10% federal penalty, or both. (A separate five-year period applies to each conversion, starting on the first day of the year in which the conversion contribution is made.)
- We recommend that you consult a tax or financial advisor on your individual situation.
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