(Bloomberg Businessweek) -- As Congress rewrote the nation’s tax laws last year, a few ideas to revamp the rules of retirement investing were floated—and quickly shot down. In the end, the legislation left 401(k)s and individual retirement accounts largely untouched. But one small provision that got into the final bill could make a big difference to retirement savers: If you convert a traditional IRA to a Roth IRA, a move that triggers taxes now but ensures tax-free income later, you will no longer have the option to change your mind. And while that doesn’t erase the appeal of switching to a Roth, it does make planning more fraught.
The Roth conversion floodgates opened in 2010 when the move became available to all savers, no matter their income. The appeal is simple: Tax-deferred retirement accounts such as 401(k)s and traditional IRAs can be tax time bombs. When you tap the funds in retirement, you owe income taxes on decades of gains. With Roths, by contrast, there’s no tax break now, but withdrawals are tax-free.
A Roth conversion can make sense when your current tax rate is lower than what you expect it to be in retirement or when your income drops dramatically, perhaps right after you stop working. “I think of it as tax insurance,” says Jeffrey Levine, chief executive officer and director of financial planning at BluePrint Wealth Alliance LLC in Garden City, N.Y. “You’re willing to spend extra money now to transfer the risk of higher taxes to Uncle Sam.”
The trouble with switching a traditional deductible IRA to a Roth is that you owe income taxes on the entire amount you convert. And while you have to make the move by Dec. 31, you likely won’t know that year’s full tax picture until you prepare your return. In the past, if the conversion pushed you into a high tax bracket or made your bill so high you couldn’t pay it, you could reverse the conversion, in what’s called a recharacterization. Same was true if the market dropped sharply after you converted, leaving you with a tax bill on investment gains you no longer enjoy. Starting with 2018 conversions, that escape route is gone.
Why the change? For one, over the next 10 years, the federal government expects to collect another half-billion dollars in taxes as a result. What’s more, this shuts down a strategy that exploited the grace period: converting multiple IRAs to Roths early in the year, investing each in different asset classes, giving all the accounts up to 21 months to rise or fall, and then recharacterizing the ones that lost money. Essentially, you could cherry-pick winners to save on taxes. “Congress didn’t want to discourage converting,” says Jamie Hopkins, associate professor of taxation at the American College of Financial Services. “What they really wanted to shut down was this tax-planning strategy.”
By lowering individual income tax rates through 2025—thus cutting the cost of converting to a Roth—tax reform has made doing so more appealing. But no more recharacterizations will require more care, says Hopkins. You may want to wait until late in the year to convert, when you can better estimate your income and deductions, or convert a big IRA balance over several years. “The strategy of serial conversions is more valuable than ever,” says Christine Benz, director of personal finance at Morningstar Inc. “If you make a mistake, it’s not as big.” Or you may choose o convert just enough to stay within your tax bracket.
If you converted in 2017, you can still undo the Roth until Oct. 15 (the extended tax-filing deadline). Congress left another escape hatch open for good: If you fund a Roth and later learn your income was too high to qualify—in 2018 that’s a modified adjusted gross income of $199,000 for couples filing jointly, $135,000 for singles—you can recharacterize it as a traditional IRA. Tax reform also left alone a system for savers who earn too much to fund a Roth IRA. With a so-called backdoor Roth, you contribute to a nondeductible IRA and convert it immediately. Since the original contribution is with after-tax money and you don’t leave the account invested long enough to see gains, this conversion should be tax-free. However, you could owe taxes if you own other IRAs funded with pretax money. In that case, a backdoor Roth can be messy tax-wise, notes St. Louis CPA Mike Piper, author of the Oblivious Investor blog. If not, he adds, “it’s a clear win.”
To contact the author of this story: Ellen Stark in New York at egstark@gmail.com.
To contact the editor responsible for this story: Dimitra Kessenides at dkessenides1@bloomberg.net.
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