While most provisions of the tax overhaul known as the Tax Cuts and Jobs Act are set to expire at the end of this year, there is one important exception in the domain of retirement planning — the elimination of the so-called Roth conversion “recharacterization” rules.
The vast majority of provisions in the 2016 tax legislation came with a year-end 2025 expiration date, explains the retirement planning expert Ed Slott of Ed Slott and Co., from the significant increase in the lifetime estate tax exemption to the lower overall tax brackets. But regardless of what happens with the much-debated TCJA extension this year, the limits on Roth conversion reversals are here to stay.
That raises the stakes for anyone considering Roth conversion strategies, as one’s ability to undo the conversion is now significantly curtailed.
Slott explores these stakes in a recent video interview conducted by Morningstar’s Christine Benz, along with his broader expectations regarding the pros and cons of the likely TCJA extension.
Overall, Slott is in the camp that believes full Republican control of the federal government makes the TCJA extension more or less a sure thing. There could be some significant sticking points along the way, particularly the debate about whether to change the rules regarding state and local tax (SALT) deductions, but extension currently seems to be the likely outcome.
Whatever happens, Slott says, Roth conversions must be undertaken with due care.
Roth Conversions Remain Attractive
According to Slott, Roth conversions are a potentially powerful strategy that can result in clients reaching retirement with substantially higher amounts of after-tax savings — hundreds of thousands of dollars more in some cases. The strategy essentially allows people to "lock in" their tax rate today, and it can be especially useful for people with big pretax retirement accounts during years with low income.
Roth conversions can also be useful in cases of inherited individual retirement accounts, especially since the Setting Every Community Up for Retirement Enhancement (Secure) Act of 2019 upended the withdrawal and taxation rules for inherited IRAs for most non-spousal beneficiaries. The law established a 10-year rule for inherited IRA withdrawals that eliminated the popular, but at times controversial, ability to "stretch" distributions across most beneficiaries' lifetimes.
The law and its follow up Secure 2.0 Act also included a significant number of other important policy changes that financial advisors and their clients have to grapple with in the income planning and estate process. The end result of all this is that people who inherit IRAs in the next decade are going to be surprised by the level of taxes they're expected to pay — unless they inherit Roth IRAs.
As Slott has previously discussed with ThinkAdvisor, tax rates are low from a historical perspective, and there are big budget pressures facing the federal government in the years ahead. Thus, while the TCJA could be extended for another five or 10 years, it’s hard to see a longer-term future where tax rates remain as low as they currently are. This means the traditional IRA is in a precarious position, as the funds in such accounts are not avoiding taxes — they are merely delaying them.
And so, a future with a high likelihood of higher taxes makes the Roth account type look especially attractive today, Slott says. Nonetheless, with the current (and seemingly permanent) restrict on recharacterizations, it’s important to get the planning math right the first time.
“If you are converting to a Roth, you better know how much it’s going to cost, because you’re in for the long term,” Slott warns. “There are no do-overs. … That provision from the Tax Cuts and Jobs Act is permanent. So, even if they extend it, that’s not coming back.”
A Word on the SALT Debate
Slott says his sense is that the TCJA will be extended this year, but like many others, he is hesitant to project exactly when that could happen.
“I think [the Republicans] will get it done,” Slott says. “They have the majority in the House and the Senate, and the White House, so they know they can pass something. Now, it’s really just about fighting among themselves. For example, one of the big fights is over the SALT.”
The SALT cap, which was put into place in 2017 and is set to expire after 2025, limits the federal deduction for state and local income, sales and property taxes to $10,000 per federal return. While proposing to make most of the 2017 tax reform changes permanent, President Donald Trump has also proposed eliminating this cap on the deduction for state and local taxes entirely.
That would be an expensive proposition, Slott observes, but it might also be necessary in order to get Republicans in high-tax states such as New York and California to vote to either temporarily or permanently extend the TCJA.
“I think I’ve seen five different versions of [SALT reform being floated by lawmakers],” Slott says. “That’s one area where they might be fighting against other states that don’t have high taxes or have no state income tax, like Florida, for example.”
Pictured: Ed Slott
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