Tax reform may have eliminated the significant “loophole” that allowed clients to reevaluate a Roth IRA conversion and potentially undo the transaction with the benefit of hindsight, but it also created a potentially valuable tax planning strategy for 2017 and 2018.
Clients now have the rare opportunity to create tax savings through the use of planning strategies that take advantage of the differences in ordinary income tax rates pre-reform and post-reform. The Roth IRA conversion and recharacterization rules present one area where clients can benefit—but as reform did eliminate certain key strategies and the new tax rates are only temporary, the window for executing and profiting from the difference in tax rates may be brief.
The Recharacterization Window
The 2017 Tax Act eliminated a client’s ability to recharacterize a conversion from a traditional, SEP or SIMPLE IRA to a Roth IRA after December 31, 2017. However, clients who executed Roth conversions for the 2017 tax year still have until October 15, 2018 to recharacterize the transaction under the previously existing rules.
As is typical with a client considering a recharacterization, growth on the post-conversion account is the primary factor to be considered when determining whether it is best to undo the Roth conversion (it’s important to wait as long as possible when evaluating the performance of the account, in order to ensure that the client doesn’t miss out on any last-minute increases prior to the October 15 deadline).
Because of the new tax rates, however, the pre-reform and post-reform tax liability must also be taken into account. Many clients are likely in a lower ordinary income tax bracket in 2018 than they were in 2017, meaning that the up-front tax cost of the conversion will likely be lower at the 2018 rates.
If the client’s Roth account has not generated meaningful gains before the October 15 conversion deadline, the client will likely benefit from recharacterizing the transaction and avoiding the pre-reform tax liability. He or she then will have the opportunity to re-convert those funds, paying taxes only at the lower post-reform rates and realizing the associated tax savings.
If the account has produced more than negligible gains, the client and advisor should run the numbers to determine whether recharacterization can be beneficial—taking into account the fact that any gains on the account value can eventually be withdrawn from the account tax-free.
Of course, clients who choose to recharacterize and later re-convert the funds in order to take advantage of the new tax rates must be advised that any Roth conversions are now permanent. The lack of permanence in the new individual income tax rates must also be considered—assuming tax rates increase after 2025, the 2018-2025 window may be the most valuable time for a client to consider a Roth conversion from a tax standpoint.
Profiting From Tax Rate Change
Many clients may not realize that they have until the tax filing deadline (April 17, 2018) to contribute to an IRA and have it count toward the 2017 tax year. These 2017 contributions to a traditional IRA allow the client to convert pre-tax funds at the old (generally, higher) tax rates—meaning that the reduction in a client’s taxable income would typically be more valuable than it would be under the new 2018 tax rates.
The client would then have the opportunity to convert those funds to a Roth IRA at lower, post-reform tax rates (paying taxes on the converted funds only at the lower 2018-2025 rates).
In general, any client who executed a Roth IRA conversion in 2017 must be advised that it’s necessary to review the transaction in order to take advantage of the brief window for recharacterizations post-reform—and the new tax rates will also play a significant role in calculating the current value of a 2017 conversion.