Contribute Your 2020 RMD to a Roth IRA

Contribute Your 2020 RMD to a Roth IRA

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Less than four weeks ago on March 27th, President Trump signed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This 880-page legislation includes four pages that waive required minimum distributions, or RMDs, for 2020 for traditional IRAs, workplace retirement plans, and inherited traditional and Roth IRAs.

As was the case in 2009 when RMDs were also waived, if this wasn’t done in 2020, many individuals, especially older ones, would be upset that they would be forced to sell deflated assets to satisfy their RMD and avoid a 50% penalty.

What if you have already taken your 2020 RMD, a portion of your RMD, or IRA or other retirement plan distributions greater than your RMD? You have three options, with #2 and #3 inapplicable to distributions from inherited traditional and Roth IRAs:

  1. Keep
  2. Return
  3. Contribute to a Roth IRA

Let’s examine the pros and cons of each of the three options.

Keep

If you have already taken distributions from taxable retirement accounts, including RMDs, you can simply keep them. If you took a distribution before February 1st, this is your only option.

Any distributions that you keep are subject to ordinary income tax to the extent that the distribution exceeds your basis. Basis includes a pro-rata amount of nondeductible contributions in the case of an IRA and after-tax contributions if the distribution came from a 401(k).

Options #2 and #3 generally aren’t viable planning strategies for retirees who depend on RMDs to cover basic expenses. Although the amount changes from year to year, it’s a systematic payout and, as such, is comparable to a structured distribution from a variable annuity.

Return

As discussed in my April 6th post, 2020 Required Minimum Distributions Waived, the CARES Act applies the “60-day rollover rule” to determine if you can return your RMD to your Traditional IRA or other retirement plan account. Under this rule, you can rollover, or return, your distribution to the account from which it came within 60 days from the date that you received it provided that you haven’t done any other rollovers within the previous 365 days.

It’s critical to review all IRA and retirement plan transactions within the previous 365 days to determine if any other rollovers have occurred. If there was another rollover, the return of your 2020 distribution will be taxable and will be subject to a potential 10% early distribution penalty and a 6% per year excess accumulation penalty if it isn’t timely removed from the account.

On April 9th, IRS released Notice 2020-23, one of the sections of which supersedes the 60-day rollover rule, indirectly extending the 2020 RMD waiver to distributions taken between February 1, 2020 and May 15, 2020 to July 15th. As noted in the “Keep It” section, if you took distributions before February 1st, your only choice is to keep it and include it in your 2020 gross income.

The advantage of rolling over, or returning, distributions to IRAs or other retirement plan accounts is that they won’t be subject to taxation in 2020. Distributions that are rolled over, or returned, to IRAs will continue to enjoy tax-deferred growth provided that there have been no other rollovers within the previous 365 days.

Potential disadvantages of returning distributions to retirement plans outnumber those of keeping them depending upon one’s situation. They include the following:

  • Increased RMDs in subsequent years
  • Increased income tax liability in subsequent years due to increased RMDs
  • Potential increased Medicare Part B Premiums and taxable Social Security due to increased RMDs
  • Increased exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Increased exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Increased exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st

Contribute to a Roth IRA

When most people think about doing a Roth IRA conversion, they expect to transfer assets directly from a traditional IRA account to a Roth IRA account. Furthermore, while it’s possible to do a transfer between accounts located at different financial institutions, most transfers are done within the same financial institution.

There’s another way to do a Roth IRA conversion that can be used to leverage its benefits in light of the waiver of 2020 RMDs. It’s a strategy that’s been part of the income tax law since the Taxpayer Relief Act of 1997 which created the Roth IRA. If you receive a distribution from a traditional IRA, you can contribute, or roll it over, to a Roth IRA within 60 days after the distribution as a Roth IRA conversion.

The once-per-year rule discussed in the “Return” section doesn’t apply to rollovers to Roth IRAs. Furthermore, the 60-day rollover time frame has been extended to July 15th for 2020 Roth IRA conversions of distributions taken from IRAs and other retirement plans between February 1st and May 15th by IRS Notice 2020-23.

There are many advantages of employing this strategy, the first several of which are mirror images of the disadvantages of returning distributions to retirement plans discussed in the previous section. The advantages of contributing or rolling over 2020 distributions to a Roth IRA include the following:

  • Reduced RMDs in subsequent years
  • Reduced income tax liability in subsequent years due to reduced RMDs
  • Potential reduced Medicare Part B Premiums and taxable Social Security due to reduced RMDs
  • Reduced exposure to likely higher income tax rates for you and your heirs beginning in 2026 when current tax rates expire or potentially sooner depending upon results of the upcoming presidential election
  • Reduced exposure to increased income tax liability in future years for surviving spouses due to the widow(er)’s penalty
  • Reduced exposure to 10-year vs. lifetime distribution requirement and associated potential increased income tax liability for non-minor children, grandchildren, and other nonspouses who inherit Traditional IRAs and other retirement plans resulting from the SECURE Act that went into effect on January 1st
  • Elimination of taxation on appreciation of funds used for the Roth IRA conversion
  • Opportunity to do a market-sensitive Roth IRA conversion to optimize lifetime after-tax distributions to the extent that the conversion is done before the stock market recovers from its recent 38.4% downturn

The primary disadvantage of rolling over a distribution from a traditional IRA to a Roth IRA vs. returning it to the traditional IRA is that it will be subject to taxation in 2020. The other potential disadvantage is increased Medicare Part B monthly premiums in 2022 if the conversion is done when you’re 63 or older depending upon the conversion amount and your adjusted gross income in 2020.

Given the prospects for higher income tax rates in the future, the potential long-term benefits of doing a Roth IRA conversion are likely to exceed additional 2020 income tax liability and potential increased 2022 Medicare Part B premiums attributable to the conversion.

The Three Options Aren’t Mutually Exclusive

As is often the case with income tax planning strategies, the three options discussed in this post aren’t mutually exclusive. It may be in your best interest to use a combination of two or three of them to optimize your and your heirs’ lifetime after-tax retirement income depending upon your situation.

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