A major change to the tax rules starting in 2018 could leave many paying higher taxes on their investments. The new tax law means starting this year, you can no longer recharacterize traditional IRAs once they have been converted to Roth IRAs, so you’re stuck with the tax consequences even if the market drops. Going forward, investors will need to be better informed about making a Roth conversion, understanding how it works and the potential issues the rule change could cause. They will also need to have an informed understanding of where the market may be headed in the future.
Overview of Individual Retirement Accounts (IRAs)
Traditional IRAs and Roth IRAs have different tax structures. With a traditional IRA, the money you contribute today reduces your current-year taxable income. Growth is sheltered from taxes until you withdraw funds. At that time, you will pay ordinary income taxes. A Roth IRA does not allow current-year tax deductions, but it offers the same tax-sheltered growth and tax-free distributions. Withdrawals made prior to age 59.5 may be penalized. You can currently contribute $5,500 ($6,500 if your over the age of 50) to either of these retirement accounts as long as your income falls within the contributions guidelines.
There are pros and cons for each of these retirement accounts. Investors with lower incomes can benefit from the Roth IRA by taking advantage of their current lower tax bracket. For higher income clients, a traditional structure can help reduce some of their tax burden. Roth IRA vs Traditional IRA: Which Is Right for You?)
Reasons to Convert to a Roth IRA
If you have a traditional IRA, there may be a time when converting all or a portion of the account to a Roth IRA makes sense. Traditional IRAs have been around longer than Roth IRAs, which means many investors started saving for retirement under a traditional plan. Doing a Roth conversion can allow an investor to move a larger amount of funds into the Roth IRA than what additional contributions alone would permit. Having both types of IRAs allows one to create a retirement strategy with both taxable and tax-free income, so you can coordinate withdrawals during retirement that minimize taxes and reduce the chance of Social Security benefits becoming taxable.
Roth IRAs are not subject to the required minimum distribution rule that requires withdrawals begin at age 70.5, allowing continued tax-sheltered investment growth. Finally, considering we’re at historically low tax rates, it may be beneficial to take advantage of paying taxes now rather than chancing higher rates later on.
How a Roth IRA Conversion Works
Converting from a traditional IRA to a Roth IRA is fairly simple. In years past, conversions were restricted based on income, but he IRS has removed that limitation. Now you can convert any amount by simply moving funds to a Roth IRA. This can be done with a 60-day rollover from the traditional to Roth IRA, a trustee-to-trustee transfer or a same trustee rollover. The amount of the conversion is considered taxable income for the year. Unlike other distributions from a traditional IRA, there is no 10% premature distribution penalty if the conversion is made prior to age 59.5. The conversion is reported on Form 8606.
A conversion in best done near the end of the year for two reasons. The first is it allows one to have a better idea of their tax situation. The second reason is the Roth IRA’s five-year rule. The rule requires that distributions from a Roth IRA be made five years after the owner established and funded the account to remain qualified and penalty-free. A Roth IRA conversion is considered to take place on January 1 regardless of when it actually occurred during the year. For related reading, see: 3 Reasons to Convert Your IRA to a Roth IRA.)
New Rule for Roth Recharacterizations
The Tax Cuts and Jobs Act of 2017 was touted as an overhaul of the tax code, but the reality is it’s more of an overlay to the previous rules. What that means for most is the tax code now contains additional complexity. Some changes are beneficial, others are not. The new rule that prevents Roth IRA recharacterizations is one that will create financial pain in the future. Prior to 2018, if someone wanted to change their Roth conversion back to a traditional IRA, they could do it before the tax filing deadline. With extensions, that deadline was October 15 the year after your conversion took place. As of 2018, you are no longer able to do this.
How the New Law Affects Investors
Limiting recharacterizations will cause people to pay taxes on investments that have lost money. That might not be an issue while the market rises, but the impact will be severe during a recession. Let’s look at how this rule would have impacted an investor during the Great Recession of 2008. Let’s say, for example, an investor converted $100,000 from their traditional IRA into a new Roth account at the end of the year in 2007. The investor, who was married and filed their taxes jointly, added this $100,000 to their household income of $75,000 for the year. The extra income from the conversion would have been taxed in both the 25% and 28% tax brackets. As part of the conversion, the investor moved their investment in the SPDR S&P 500 ETF (SPY) fund on December 31.
On that day, SPY was trading for $147.10 a share. We all know what took place next. The market went into freefall. By the recharacterization deadline, SPY was trading at $97.46 a share. The $100,000 investment was suddenly worth $66,242. Now imagine the investor, like many others, lost their job and needed access their investments in order to survive. Under the old rule, they could have recharacterized the conversion back in order to avoid the extra taxable gain. Under the new tax law, they would have been stuck paying the extra $26,377 in taxes. That’s on top of the $33,758 loss they suffered on the investment.
Future Planning Considerations
Moving forward, Roth conversions needs to be carefully considered. Prior to this change, a client’s taxable situation needed to be carefully understood before making changes. This included understanding their current-year tax situation as well as estimating future-year liabilities. With the change, one most also consider the near-term economic conditions that could impact the stock market.
Our current near-term economic conditions seem positive. Then again, did anyone predict on December 31, 2007 what would happen the following year? If they made those predictions, did anyone listen? Keep in mind, the same climate of deregulation and tax cuts we’re in now were, in part, to blame for the Great Recession. Making a mistake prior to the rule change was an easy fix. Going forward, you’re stuck with it. A Roth conversion should only be done once you have the best information available at the time.
(For more from this author, see: Don't Miss out on Retirement Rollover Benefits.)