By: JP Pedinielli

Changes in the new Tax Cut and Jobs Act signed into law in December may impact your Roth IRA conversion strategy. The new tax law severely limits the ability for Roth conversions to be reversed after 2017. Once you complete your Roth conversion you can no longer recharacterize it back to an IRA just because you don’t like the final tax result on your 2018 tax return.  This was a valuable tax planning strategy which was a staple we used in tax planning for our clients. Since no returns are allowed, future Roth conversion decisions will require more precise estimates of yearend taxable income to obtain the maximum tax savings.

Benefits under the new tax law:

The upfront tax bill is lower – The major benefit of Roth IRAs is that your investment grows tax-free for you and your heirs. However, the tax bill on the Roth is not completely free since taxes are paid upfront on any deposits since the contribution to a Roth IRA comes from after-tax money.  With the new lower income tax rates, a Roth conversion may be more attractive as it might “cost” less than in previous years when tax rates were higher.  Additionally, with the higher standard deduction and lower marginal tax rates, there might be an opportunity to complete a larger conversion than in years past.

Roth IRAs may be free of Federal Estate taxes for clients – With the increase in estate tax exemption to $11.2 million per person and $22.4 million per couple, most clients will be able to pass more funds to their beneficiary tax free.  With the increase in exemptions, it is now easier to gift money among family members to cover taxes on a Roth conversion or help younger family members fund a Roth IRA provided, they have earned income.  Another possible strategy is having a high income client gift their parent funds to help pay taxes on a Roth conversion at the parents lower tax rate. This could reduce the parents Required Minimum Distributions (RMDs) and provide a more valuable asset for you to inherit.

Drawbacks under the new tax law:

Conversions can no longer be undone – As mentioned earlier, the biggest drawback from the new law are the rules that limit recharacterizing a Roth conversion back to an IRA.  For this reason, we generally recommend waiting until your Fall tax planning appointment to complete a Roth conversion when you have a more detailed estimate of your 2018 income to prepare the most accurate conversion estimate possible.

Conversions generally increase taxable income – Even though 2018 tax rates are lower than previous years, a Roth conversion will increase your income in the year it occurs.  The good news is Roth conversions are not subject to the 3.8% net investment income tax. However, the addition to income could trigger other taxes or limit deductions.  There is no substitute for careful yearend planning.

The most important takeaway:  don’t underestimate the need for yearend planning if you want to produce the best possible results.  Advisors that understand all aspects of your income and investments can still include a Roth conversion strategy as an integral part of your financial, estate, and tax planning strategy.