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.
Further, most clients should be advised to wait until later in the year—when their overall tax picture is clearer—to determine the appropriate amount to convert and execute the Roth conversion. It’s also important to 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.
One boost to Roth conversions, however, is the fact that tax reform expanded the tax brackets themselves, so clients take less risk in jumping into a higher bracket based on a Roth conversion. 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.
Other Common IRA Planning Strategies
The qualified charitable distribution (QCD) strategy is also one that should be examined in light of tax reform, especially for clients who learned that they would no longer be able to take advantage of itemized deductions post-reform. The QCD strategy allows clients who have already reached age 70 ½ to continue to reap tax benefits from charitable giving while taking advantage of the now-doubled standard deduction at tax time.
QCDs are actually even more valuable than the itemized deduction for charitable donations, because the QCD is both counted as the client’s RMD for the year and is also totally excluded from income if the transaction is executed properly. Despite this, clients must be advised that it’s necessary to take the QCD before taking any other RMDs for the year in order to gain the tax preference.
In other words, while QCDs themselves are excluded from income, they don’t actually offset any other RMD that’s already been taken for the year and included in income, so that many clients may wish to execute their QCD early in the year before taking any other RMDs that may later turn out to be unnecessary.
While tax reform is well behind us, the impact of the new law continues to be felt in various ways, raising issues for many clients in both their tax planning and overall retirement income planning. Although some changes may seem minor, understanding the small details is key to maximizing value for clients in the wake of tax reform.