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How to make a ROTH Conversion Tax-Free in 2020

Many people know the benefits if they convert their Traditional IRA to a ROTH IRA but are still reluctant to do it because doing so would be a taxable event. There is an opportunity right now to do it tax-free. But you need to hurry.

First let’s review some of reasons to convert a Traditional IRA to a ROTH IRA:

  • Paying taxes at lower rates after retirement
  • NO required minimum distributions from ROTH
  • Lower taxes on Social Security during retirement
  • Lower Medicare premiums throughout retirement
  • Lower tax rates for married couples vs. single
  • Eliminates future tax rate uncertainty
  • Lower Medicare surtax on retirement income
  • Tax free distributions for beneficiaries
  • Estate planning considerations

So how can I have my cake (the ROTH Benefits) and eat it too (avoid the taxes on conversion)? You will need to hurry.

Recall that the CARES Act enacted on March 27, 2020, changed the limitations that are usually placed on charitable gifts. Ordinarily, cash contributions are limited to 60% of your adjusted gross income in the year the gift is made. Recognizing that charities are also hurting from the impact of the virus, Congress modified the limits for 2020. This year, and this year only, the deductible limit is 100% of adjusted gross income.

So the solution can be as simple as converting a portion (or all of) your Traditional IRA to a ROTH IRA and making a qualifying charitable contribution of the same amount. The contribution should not come from your IRA. It will come from your other accounts. To qualify for the higher limit, the gift must be a cash contribution directly to the charity. That is, it cannot be appreciated assets or made to start or maintain a donor advised fund. But you need to hurry and get both done in 2020.

I am making the assumption you itemize deductions on Schedule A of your tax return. Your charitable giving added to your other itemized deductions (medical and dental expenses, taxes you pay, interest you pay, casualty and theft losses, and other itemized deductions) must exceed the standard deduction allowed for your filing status. The standard deduction was increased by the Jobs Act in 2017.

Your financial advisor should be able to prove the benefit of this strategy by modeling various scenarios. We typically model this in two ways:

  • conversion vs. no conversion (status quo) this year
  • conversion with charitable contribution this year vs. next year

As with any significant tax maneuver, you should consult with your own tax advisor / preparer before making either of these moves.

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Need a reason to prepare the FAFSA? Here are 4.

Many have asked whether, given their family’s level of assets and / or income, they should go to the trouble of filling out the Free Application for Federal Student Aid (FAFSA). If you are a high school or college student (or the parent of one) that plans to attend college in the fall of 2021, the short answer is an unqualified “YES, do it now.” I believe that every student’s family should complete the FAFSA. Completing the FAFSA is a family affair–it involves the collection of data on the student as well as the parents or guardian.

Colleges and universities are run like businesses these days. They are competing for certain students and the admissions departments are busy evaluating students to see who gets in and who doesn’t. They use terms like “holistic” or “comprehensive” to describe the selection process. That means that a certain GPA or involvement in extracurricular activities are not the sole minimum requirements. They consider the whole package, including the family’s ability to pay for the education. The FAFSA shows the college your ability to pay.

Even if you think student loans are the work of the devil and you would not, at this moment, ever think of borrowing for college, submit the FAFSA anyway. FAFSA is also used for other forms of financial aid. The U.S. Department of Education awards $120 billion a year in grants, work-study programs and loans.

Here are some other reasons why you should complete the FAFSA:

When the FAFSA is completed, the Expected Family Contribution (EFC) is generated. Colleges determine financial need by subtracting your EFC from the Cost of Attendance (COA) at their school. Bear in mind, that the EFC is an estimate of your family’s ability to pay. Your ability to pay may actually increase or decrease before the child enters school next year. Life sometimes throws curve balls at the best laid plans. Schools can use professional judgement in their awards. When that happens, the first thing a school is likely to ask for is the FAFSA.

The chief reason for completing the FAFSA is to become eligible for Direct Federal Loans. High-income families will not likely qualify for Direct Federal Subsidized Loans, but by completing the FAFSA, they will become eligible for Direct Unsubsidized Federal Loans. The interest rate for undergrads is low enough to consider this source of capital.

Completing the FAFSA, along with the college application, puts the ball in the court of the admissions office. They don’t have to wait until after the FAFSA deadline (which can vary by state and school) to provide a financial aid award letter. The sooner you get the award letter, the sooner you know the net cost of college, and the sooner you can begin the award letter appeal process if the letter is unfavorable. We will deal with appealing award letters in a later blog post.

Because the Direct Federal Loan has an annual and a lifetime limit, it has become very important to project the entire cost of college from matriculation to graduation. Cash flow planning and debt structuring become crucial parts of a family’s financial plan when their student is headed off to college. Direct Federal Loans for undergrads are usually cheaper than the Federal Grad Plus loans. Therefore, sometimes it makes sense to borrow for undergrad education and save resources for graduate or professional school. A plan for repayment should also be developed before the money is borrowed. Because paying for college is likely to be the second largest expense for a family a complete college financial planning package should include a plan to reduce the cost of college, college cost comparisons, debt analysis, student loan repayment, and public loan forgiveness planning.

Federal funds are limited, and many states award their grants on a first-come, first-serve basis. So do it NOW.

Here is what you will need:

  • Social Security numbers for student and parents if student is a dependent
  • Driver’s license number if you have one
  • Tax returns including forms W2 for student and parents if student is dependent
  • Any records of untaxed income.
  • Asset records for cash, checking accounts, investments, real estate, business and farm interests.

Let us show you how to reduce the cost of college. For a free resource called 4 Keys to Cutting College Costs, click here.

Updated October 1, 2020

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Is this a new normal?

Do you call the time BC (before Covid-19) normal? Do you join me in hoping that life can get back to normal soon, but have serious doubts about that? What if this is normal? I believe we need to talk about what we have learned and how we might think about going forward.

7 Things to think about now

  • Ordinarily we financial planners are demonstrating the value of working longer, i.e. postponing retirement. But this month, we have been more engaged with evaluating those clients who are thinking of retiring earlier than originally planned. If you are eligible and have the assets or guaranteed income to retire now, this could be an attractive scenario. Of course, an early retirement nearly always results in less to spend for the rest of one’s life. I know that it might feel scary to even think about, but now would be a great time to determine the true cost of retiring now. Social security benefits factor into that and a Social Security Timing Analysis would be great place to start.
  • Do you find one of the benefits of being quarantined is that you are spending less and saving more? If you are like many we have talked with, your expenses have dropped a lot over the past three months. (I have bought one tank of gas since February and I still have a fair amount of it left.) Perhaps you have some pent up demand to get back out to restaurants or to travel, but several people tell me that they have been surprised to learn what they can do without. That doesn’t bode well for our consumption and debt-based economy, but it could truly be our new normal. Could these past couple of months be a good representation of what retirement spending looks like? You should add in some fun however, just to be safe.
  • Do you need a vacation? Like many of you, I still don’t feel safe getting on an airplane or cruise ship. The opening up of various countries is going to likely be pretty chaotic. Leaving the U.S. might be easy, but getting back in from some of the hot spots around the world could be harder in the coming months. We’ve heard more than one person plot their vacation with a plan to stay within a comfortable drive from home. Popular U.S. destinations could even get to be crowded, so if this is in the cards for you, plan early.
  • Of course, it’s never fun to think about updating your estate plan, but we are in the middle of a life-threatening pandemic. If not now, when? We can help you review your existing plan by mapping the current estate structure into a flowchart. We would then make suggestions for you to discuss with your lawyer if you don’t like the results. That’s all I will say about that.
  • I think you will agree that insurance of various types represents protection. It would be a good idea to review your current policies and to determine if you have the right type and the right amount. I was able to get my auto insurance premium reduced considerably with a revised estimate of how much I think I will drive in the next twelve months. It took about 15 minutes to save 15% and I didn’t have to switch to that popular company to do so.
  • Is it time to re-finance? Consider how much debt is appropriate for your current circumstance. And while you are at it, consider the kind of debt and the interest rate on any debt that you carry. We heard about sub-3% interest rates on home mortgages this week. Prime is 3.25%. Refinancing current debt loads should probably be high on your list. You are going to hear a lot about personal de-leveraging (paying down debt) as we move into the new normal. We see a lot of people switching from 30 year mortgages to 15 year.
  • Tax laws have changed a lot this year as a result of stimulus measures. Required minimum distributions from retirement plans have been waived entirely. If you have already taken your RMD, you can roll it back into the IRA and avoid paying the tax. You should likely consider a ROTH conversion this year. The first two estimated payments for 2020 have been delayed until July 15th, along with the filing deadline of 2019 returns. Student loan payments and interest have been deferred. The treatment of charitable contributions has changed. If any of these provisions could benefit you, a revised tax projection for 2020 and 2021 is in order.

It is so easy to let inertia set in and avoid any consideration of money issues. But as I’ve often said, “Better decisions today yield better outcomes tomorrow.” Your financial plan is your road map and it should be dynamic enough to handle multiple scenarios for casting a best-case, worst-case, and somewhere in the middle. If nothing else, these last three months should have been instructive in thinking about risk tolerance. We are here to help you with any of these things. Reach out with any questions. We are a phone call or ZOOM meeting away.

June 29, 2020