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.