What will 2017 or even 2018 tax rules look like? Going into summertime it’s starting to look like any major tax reform may not be effective until 2018.
One thing is for sure, though: Roth conversions will be affected, both the conversions already done and any future conversions being contemplated. Financial advisers should use the summer to evaluate all 2016 and 2017 Roth conversions for clients.
Remember that the core of Roth IRA conversion planning is not how much you convert; it’s how much of that conversion you keep. Or put another way, how much of the conversion is recharacterized or even re-converted.
First, let’s review the Roth conversion options.
A client can convert to a Roth IRA, recharacterize (undo) all or any part of that conversion and even re-convert those same funds or convert other funds. When the conversion is done, the pre-tax converted funds will be taxed at ordinary income tax rates, but there is never a 10% early distribution penalty.
All or any part of a Roth conversion can be undone by recharacterizing it back to a traditional IRA by Oct. 15 of the year after the conversion. The recharacterization requires the converted funds along with the income or loss on those funds to be directly transferred back to a traditional IRA.
Those same converted funds which have now been recharacterized can be re-converted, but not until the year after the conversion or 30 days after the recharacterization, whichever is later. Other IRA funds can be converted at any time, since the waiting period does not apply to funds not yet converted before.
In essence, that is the Roth conversion planning cycle: the Roth conversion, the recharacterization and the re-conversion.
Now to the planning in light of uncertainty about tax reform.
First, evaluate all 2016 Roth conversions now. Speak with clients. You probably already know or have a good idea of the tax cost of these 2016 conversions. Let clients know that with tax reform looming, the tax bill could be lower in the future. It might pay to recharacterize those funds and wait it out until next year for a lower tax cost.
But before undoing that conversion, the status of the converted funds must be reviewed.
Have the converted funds appreciated substantially since being converted to the Roth IRA? If so, that would have to be factored in and may be a reason to keep that conversion. Even a future lower tax rate can end up costing more if it is on a higher balance.
If the client took advantage of a low tax bill in 2016 due to business losses or high deductions that year, that may also be a reason to keep that conversion. The client may also be on a plan to do smaller annual conversions to make the most of the lower tax brackets each year. But even in that case, looking ahead to a lower future tax rate may be a reason to undo part or all of the 2016 Roth conversion and wait it out until next year.
What about 2017 Roth conversions? If clients have already done them, advisers have more flexibility and waiting time since those conversions can be undone up to Oct. 15, 2018. By that time, hopefully there will be more tax rate certainty.
For clients who have not yet converted IRA funds to Roth IRAs but are thinking about it, it might be wise to delay these conversions until we have a new tax law. However, each client has their own situation, and a Roth conversion now could still pay off without waiting for lower tax rates if the funds are expected to appreciate substantially before then. Along those same lines, look at converting IRAs with depressed values.
Bets can also be hedged by converting different investments to separate Roth IRAs providing more flexibility in recharacterizing only some conversions.
Remind clients that it’s not an all or nothing approach. Partial conversions and recharacterizations are permitted and can be used to tailor the timing for the optimal Roth conversion.
Article Published by InvestmentNews June 23 2017
Written by Ed Slott