Retirement and RMD Refresh
In times like these, it helps to refresh what we know on two important topics: retirement planning and Required Minimum Distributions (“RMDs”). Recent legislative developments and the COVID-19 pandemic response have created opportunities with these two topics.
Roth IRAs are a fantastic retirement tool allowing an individual to set aside up to $6,000 ($7,000 if over age 50) of taxable earned income leading to future tax-free qualified distributions. There are income phaseout thresholds for direct contributions to a Roth IRA (starting at $124,000 for single taxpayers; $196,000 for married filing joint taxpayers for 2020). If the taxpayer’s income exceeds those thresholds, they must first do a contribution to a Traditional IRA and then convert it to a Roth IRA. If there was no existing traditional IRA prior to the contribution for the conversion, the transaction will be tax free. If there was an existing traditional IRA prior to the contribution, then a portion of the transaction may be deemed taxable.
Opportunity knocks with the current market volatility. Let us assume as of 12/31/2019 there was $40,000 in a traditional IRA with a basis of $15,000. Assume in recent months the value of the traditional IRA dropped down to $28,000. If the full balance of the traditional IRA was converted to a Roth IRA, the taxable portion would be $13,000 ($28,000 converted less basis of $15,000). This means there is an opportunity to pay less in tax on a Roth IRA conversion simply because the taxable portion, the unrealized growth in the IRA, has decreased.
Suppose in 2020, a small business owner is going to realize a net operating loss. This would create a situation where a traditional IRA could be converted to a Roth IRA and use up or offset some of the net operating loss for the year.
Suppose another individual lost a good portion of income for 2020, dropping down to a lower tax bracket but has remained financially stable. If this person has the cash flow to cover the taxes on a Roth IRA conversion, it would be an option to consider while the market is down.
Why bother converting to a Roth IRA? As noted above, qualified distributions from a Roth IRA are tax-free (under current tax law). The time value of money in the Roth IRA could be explosive, dependent upon actual returns and the length of time the money can sit there and grow. Also, we are currently in a period of very low tax rates. Given the various stimulus packages utilized over the past 12 years and the burgeoning national deficit, it is likely we will see higher tax rates in the future. Additionally, Roth IRAs do not require minimum distributions when you attain a certain age. Therefore, the investment continues to grow tax-free for longer and future beneficiaries who inherit the Roth IRA would take distributions tax-free. Lastly, in times like these, some people find they need access to cash. Provided the Roth IRA was open for 5 years, the contributions to a Roth can be withdrawn without penalty or tax. The growth portion, if withdrawn, would be taxable income if the Roth IRA owner was not yet age 59 ½ at the time of withdrawal.
What are the COVID-19 impacts on Required Minimum Distributions? Prior to December 2019, the tax law stipulated once a taxpayer attained age 70 ½, they were required to start taking distributions from their traditional IRA, SEP IRA, or SIMPLE IRAs. Under the SECURE Act passed in December 2019, for those born after June 30, 1949, RMDs must start at age 72. Due to COVID-19, there is no mandated RMD for 2020 as taking funds out during a downturn in the market could solidify losses and reduce recovery in a rebound. It is important to note if the individual was still employed and had a 401(k) with the employer, the RMD would start the year after retiring. The RMD is determined by looking to the value as of December 31st and dividing by the distribution period reported un the Uniform Lifetime Table for the taxpayer’s age at the end of the year.
What about pulling funds from IRAs due to COVID-19? Congress recognized the need for cash by individuals and relaxed the rules on distributions from retirement savings for those individuals impacted by COVID-19. Impacted means the individual was diagnosed with the virus, lost their job, were furloughed, experienced reduced work hours, or due to COVID-19 could not work or had no childcare. (This is a pretty wide net.) Impacted individuals can now pull up to $100,000 from their IRA. The $100,000 limitation is per individual, not retirement account. There are three scenarios discussed below: pull funds out of retirement without repayment, borrow funds temporarily, or borrow funds for a longer period. The downside to these options is obvious: pulling funds out of a retirement plan will set back retirement planning and reduce the potential growth over time as there is less in the bucket. However, if there is a desperate need, these options warrant consideration.
- If the funds are pulled and not redeposited, normally the individual would be subject to a 10% penalty under age 59 ½ and the distribution would be subject to income tax at both the Federal and state levels. Due to the COVID-19 pandemic, the relief is waiver of the 10% penalty and allowing the Federal tax owed on the distributions to be paid over three years instead of one, if desired. It is important to recognize states will have their own rules and could still require taxes on the distribution by April 15th of the following year, potentially impacting estimated tax payments.
- If the funds are redeposited into the retirement account within the three years (instead of the traditional, pre-pandemic 60-days), no tax is owed on the distribution. Since tax filings are due on an annual basis, this option would require filing amended returns to get back the taxes paid on the initial withdrawal.
- Another option is to temporarily use retirement funds as a loan for a longer period. Prior to the COVID-19 pandemic, if an individual borrowed funds from their 401(k), they would be limited to 50% of the vested balance and must repay the loan over five years. The stimulus package changed the rules allowing up to 100% of the vested to be borrowed and repay over six years. Typically, a low interest rate applies on the borrowed funds and the interest is paid to the individual’s own 401(k). However, the interest rate charged does not make up for any lost earnings while the funds were borrowed.
During these times of uncertainty, we’re here for you as we always have been. We encourage you to connect with us directly so that we can discuss your specific needs around retirement planning and Required Minimum Distributions, as well as other issues pertinent to you.