For individuals who earned less money last year, there’s a silver lining.
Two tax moves can ease the pain that 2020’s COVID crisis wreaked upon many people’s take-home pay. Here’s how some financial advisors have been turning a client’s reduced bonus, salary cut, downturn in business profits or no-pay furlough into a future pot of money with tax benefits down the road.
Do a Roth IRA conversion
The move morphs a traditional IRA’s pre-tax dollars — upon which tax is later owed, at ordinary rates now topping out at 37% — into a Roth’s tax-free gains and tax-free withdrawals in the future. Individuals can owe tax upon their traditional plan’s gains when converting, but there are ways around that.
Why convert now? Advisors say it’s because you can lock in the lowest individual tax rates in a generation before they’re due to expire in 2026 (unless Congress extends them). First, the move allows you to snag the benefits of the lower tax bracket you may have fallen into last year when your pandemic-dinged earnings dropped, and potentially to keep that lower rate in retirement. Second, even if you’re not in a lower tax bracket for 2020, an individual may pay less tax simply because they earned less money.
Conversions for 2020 income had to be done on paper by the end of last December, while those for this year’s income must be done by year’s end. Either way, a taxpayer has until the following April 15 to fund the new account.
“If your income is lower due to a lower bonus, loss of income, you were furloughed, we’ll convert,” says Ka’Neda Bullock, a CFP and retirement plan advisor and the founder of Master Plan Investment Group in Pennington, New Jersey.
Bullock uses a strategy for clients that she calls “mirroring the loss of income.” That involves funding a Roth IRA with an amount equal to the income that the client lost during the pandemic.
Under the method, taxpayers with reduced income last year who already have a traditional IRA or traditional 401(k) convert all or part of those accounts to a Roth version. Taxpayers can offset the tax bill immediately owed on the conversion by kicking in an amount equal to the converted amount to their traditional plan, with that amount equal to the loss of income that year. Doing so makes the taxes due on the conversion a wash, due to the deductibility of the contribution to the traditional plan, Bullock says. “The income loss equals the amount converted to a Roth,” she adds.
Say a client normally makes $100,000 a year, but last year earned only $90,000, because his bonus was axed. Taking that lost $10,000 out of his traditional IRA and moving it to a Roth IRA means taxes are owed on the shift. Still, the client would not pay any more tax in 2020 than he did in 2019, when he made $100,000. That makes the tax cost of the conversion essentially a “wash,” Bullock says.
A version of her strategy involves a client taking advantage of falling temporarily into a lower tax bracket. Say a client who normally makes $150,000 made only $75,000 last year due to a furlough by her pandemic-stricken employer. Before Covid, she was in the 24% tax bracket, but now she’s in the 22% bracket. The bracket shifts once a taxpayer makes $85,528. This leaves about $10,500 available to invest at a tax rate of the lower 22% (and a tax bill of around $2,340, vs. $2,520 at 24%). Bullock says she converts $10,500 in the client’s traditional IRA to a Roth IRA to capture those immediate tax savings and seed a pot of money that, unlike the client’s traditional IRA, can grow tax-free.
As the April 15 filing deadline looms, it’s not too late to do a conversion for last year’s tax purposes. As long as an IRA — traditional or Roth — is opened or already in existence and funded by April 15, the tax benefits will apply to the return filed for 2020.
If clients expects their earned income this year to bounce back and put them in a higher tax bracket come tax time in 2022, “conversions are good now, especially if you were 24% in 2020 but expect to be back to 30% in 2021,” says Jason Uetrecht, a CPA and CFP in the Wealth Advisory Services Group at accounting firm RubinBrown in St. Louis, Missouri. He says he’s done an increased number of conversions this tax season.
With a conversion, even a large one, some individuals who own small businesses organized as an S corporation or other pass-through entity can soak up all the tax due. An investor with a small business that suffered a collapse in profits due to the pandemic can use its net operating losses to offset all the tax due on a conversion, according to a
Set up a backdoor Roth IRA
Roth IRAs have contribution limits ($6,000 a year, or $7,000 if 50 or older), as well as income cut-offs. They’re technically off limits to higher earners with income that reaches or tops $139,000 (if single) or $206,000 (if married).
Still, affluent individuals can sneak their way in.
Here’s how: A high earner makes a contribution (of those same $6,000 or $7,000 contribution limits) to a traditional IRA. Because the earner is over the income limits, she can’t deduct the contribution on her federal return.
Next, the earner immediately diverts her newly-stuffed IRA into a Roth IRA. Because the original contribution was made with after-tax dollars, there’s no tax bill on that backdoor conversion. Repeat the move every year, and move more money into a tax-free Roth without owing tax on the shift. “It’s a loophole in the tax law,” says David Medina, a CFP, investment advisor representative and founder of Stewardship Financial in Arcadia, California.
But there’s a landmine to avoid.
When determining your tax bill on a conversion from a traditional IRA to a Roth IRA, the IRS looks at the value of all of your traditional IRA accounts combined.
That means a backdoor conversion eliminates the tax due on the shift only if an individual doesn’t have another traditional IRA that’s funded by pre-tax contributions for which she takes deductions. Put otherwise, having a traditional IRA with deductible contributions “will blow up your backdoor Roth IRA,” Medina says
To avoid that situation, Medina says, “you need to ditch your pre-tax IRA” by first rolling it into a 401(k), whose balances the IRS doesn’t consider when calculating the tax due on conversions. “Now you no longer have that pre-tax IRA to blow you up, he says, “and no tax is owed on the conversion."
