With the 2018 tax season now well behind us, advisors and clients alike have gained a much sharper understanding of how tax reform’s changes impact clients’ tax planning calculus. One thing that’s certain is that tax reform has most certainly changed the playbook when it comes to strategies for executing Roth IRA conversions and other popular IRA planning strategies.
For many clients and advisors, the bottom line is that effective communication of the client’s overall financial picture can be key to ensuring that many still-popular IRA planning strategies are executed properly to gain the best possible results from a tax standpoint—and to avoid traps along the way.
Spotlight on Roth IRA Conversions
One of the most significant retirement-related changes in the new tax law is the repeal of a client’s ability to recharacterize (undo) a Roth IRA conversion. This new rule applies for conversions that occur in tax years beginning in 2018 and beyond.
As most clients know, 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 October 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 gave the client ample time to evaluate his or her financial position, overall tax liability and performance of the converted retirement funds to determine whether the conversion was a smart move from a tax perspective—and to undo it if the answer was negative.
Because clients no longer have the luxury of the recharacterization option to fall back on, the analysis surrounding whether a client should convert must be much more detailed. Advisors must understand the client’s entire anticipated tax position for the year. This means that the client must ask much more detailed questions to understand whether the client expects any unusual income for the year that could cause the client to jump tax brackets or, conversely, whether any large deductions are expected.
Small-business clients should also understand the potential impact that a Roth conversion may have on their ability to take advantage of the 20% qualified business income (QBI) deduction under Section 199A, which phases out once the client’s income reaches higher levels for certain types of businesses.