Many clients interested in Roth IRA conversions point to the 2017 tax reform legislation as a negative in their pro/con list, as tax reform eliminated the ability of taxpayers to recharacterize Roth conversions when things don’t go as planned.

Despite this, tax reform may have actually opened a huge window for clients looking to do Roth conversions while minimizing their tax liability for these conversions. The new tax rate system, combined with the general “moodiness” of the stock market of late, have created conditions that can make Roth IRA conversions attractive for an entirely new group of clients despite the inability to undo the transaction at a later date.  With proper planning, these clients may be able to benefit substantially from a Roth conversion strategy without even jumping income tax brackets.

Roth IRA Conversions: The Basic Attraction

When a client converts an IRA to a Roth, he or she pays taxes on the entire value of the amount converted at his or her current ordinary income tax rates. Under pre-reform law, however, the client had until Oct.15 of the following year to recharacterize the conversion and eliminate the associated tax liability (the funds were essentially transferred back into the traditional IRA as though the conversion never happened). This “recharacterization” option was eliminated for Roth conversions taking place after 2017—permanently (or as permanent as anything in the tax code can be).

Despite the fact that the client must include the amounts converted in ordinary income for the year of conversion, once those funds are converted to a Roth, they grow tax-free. Assuming that the client leaves the funds in the Roth to grow, the potential for tax-free growth can be substantial.

Because withdrawals from the Roth are also tax-free, the client can use that source of funds to keep tax rates low during retirement, once the client also becomes subject to the required minimum distribution rules and must begin taking taxable distributions from any traditional retirement accounts (Roth IRAs impose no requirements with respect to lifetime distributions).

Generally, Roth conversions are most attractive for clients who expect that their retirement account assets will perform better at some future date, and for clients who think their tax rates might increase in the future.

Evaluating Roth Conversions in Today’s Tax Environment

The fact that clients pay income taxes on converted amounts currently is usually a deterrent for taxpayers in their prime earning years, who actually generally expect that their tax rates will decrease in the future.  Tax reform changed the math for many of these clients by both reducing ordinary income tax rates currently and expanding the brackets themselves.  For example, in 2019, the 24 percent rate bracket applies for income on a joint return between $168,400 and $321,450—under prior law, the 28 and 33 percent bracket applied to income in those ranges.

Because of this—and the fact that tax reform’s ordinary income tax rate structure is set to expire after 2025—a new group of clients might find Roth conversions attractive while tax reform remains fully in effect.

The market dips we have been experiencing lately also make Roth conversions more attractive to some clients.  The primary reason to consider converting a traditional IRA to a Roth IRA in a market downturn involves the tax savings that such a move can generate.

As noted above, when a client converts an IRA to a Roth, he or she pays taxes on the entire value of the amount converted at his or her current ordinary income tax rates. Obviously, if the value of assets in the IRA has declined (as is often the case in a market downturn), the client can convert the IRA assets at that lower value—generating a correspondingly lower tax liability.  If the market rebounds, the growth in the Roth assets will be tax-free to the client.

Remember that clients can choose which IRA assets to convert, and can convert pieces of the IRA over a period of years to stay in the same income tax bracket over time.

Conclusion

While a large Roth conversion is now more risky than it was in pre-reform years, for clients looking to create a tax-free stream of income in retirement, the temporary low individual income tax rate window opened by the 2017 tax reform legislation may make this the best time to convert, especially for clients who are willing to put in the planning necessary to develop an overall Roth conversion strategy.

• Read previous coverage of Roth conversion planning in Advisor’s Journal.
• For in-depth analysis of the tax treatment of Roth IRAs, see Advisor’s Main Library.
• Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.