Roth Conversions When Tax Reform Is in the Works

The potential for major tax reform or tax cuts makes it harder to decide this year whether to convert a traditional IRA to a Roth IRA.

Congressional leaders and President Trump say they are determined to push through tax reform this year. We don’t know details yet, but it’s clear that individual income tax rates are scheduled to be lower for most taxpayers than under current law, and lower tax rates affect IRA conversion decisions.

We’ll start with a review of how to decide whether to convert a traditional IRA to a Roth IRA. Then, we’ll see how the analysis might be affected by tax reform.

Anyone can convert a traditional IRA to a Roth IRA. The income limit on conversions was repealed years ago. The advantages of a Roth IRA are there are no required minimum distributions (RMDs) during your lifetime and, after a five-year waiting period, all distributions of income and gains are tax
free. Your beneficiaries will have to take RMDs over their life expectancies, but their distributions will be tax free.

To convert an IRA, you complete a form or web page provided by the IRA custodian. The custodian transfers assets from the traditional IRA to a Roth IRA. It is not an all-or-nothing decision. You can convert as much or as little of the IRA as you want, subject to the custodian’s limits.

There’s a price to a conversion. You include in gross income the converted amount, just as though you took it as a distribution, and it will be taxed as ordinary income. That’s why it can be a good idea to convert only part of an IRA. Convert just enough to keep from pushing you into the next higher tax bracket or triggering the stealth taxes, such as the Medicare premium surtax, reduction in itemized expenses and personal exemptions, tax on Social Security benefits, and others.

You have to do a careful analysis to determine if, in the long-term, converting an IRA might increase your family’s after-tax wealth. Don’t rely on rules of thumb or intuition, because too many factors are interacting. I recommend constructing a spreadsheet or using the many calculators available on websites. The calculators have differences, so I recommend using more than one and comparing results, especially if you’re going to use a free calculator. You also can work with a financial or estate planner who will use sophisticated software.

Here are the key factors in the decision.

Life expectancy of the IRA. The income and gains in the Roth IRA have to compound for years to make up for paying income taxes early. That’s why good candidates for conversion are those who do it relatively early or who have income and assets outside the IRA to fund all or most of their retirement
expenses. The best candidates plan to leave their IRAs to beneficiaries instead of spending them.

Rate of return. The higher the return on your investments, the more likely it is the conversion will pay off, and the less time it will take. In today’s era of very low interest rates, it could take a long time for a conversion to pay off for a very conservative investor.

Current and future tax rates. A conversion is most likely to make sense when you expect tax rates in the distribution years to be higher than today. A conversion often can make sense when future income tax rates are expected to be about the same as today. Fewer conversions pay off when your future tax rate will be significantly below today’s rate.

Source of tax payments. A conversion takes less time to pay off when the taxes from the conversion are paid with assets outside the IRA. If you take an IRA distribution to pay the taxes, the cost of the conversion is higher.

The RMD Waterfall. Under the RMD schedule for traditional IRAs, the percentage of the IRA that must be distributed each year increases, causing very high distributions in your late 70s and beyond. I call that the RMD Waterfall, and it disrupts the tax and estate plans of people who plan to leave their IRAs to beneficiaries. A conversion eliminates the RMD Waterfall and its higher taxes.

Don’t forget that if you’re over age 70½, you have to take your RMD for the year before converting any of the traditional IRAs.

You can see how tax reform, or even a simple tax rate cut, would affect the decision to convert an IRA. A conversion makes less sense when tax rates will be lower in the future. Conversions still will make sense after tax reform, but probably not for as many people. A more immediate effect is that if tax rates are lower in 2018 than in 2017, the cost of converting the IRA will be lower next year. A lower cost can make
for a profitable conversion even if rates are lower in the future.

How should a taxpayer act with the potential for tax reform or rate cuts in the air?

One option of course is to wait. Don’t consider a conversion until after the results of the tax reform efforts are clear.

The downside of waiting is you could miss an opportunity to convert. Tax reform could fail, just as repealing the Affordable Care Act failed. You’d miss the opportunity to convert this year. Another year of gains and income will be in the traditional IRA instead of in the Roth IRA.

Also, a conversion might be especially good for you this year because of unique circumstances. You might be in a lower tax bracket than usual because of a onetime decline in income or an increase in
deductions. Delaying could cost you this unusual set of favorable circumstances.

The second option is to convert and monitor.

Initiate a conversion when it makes sense based on your current situation and best estimate of the future. But continue to monitor the situation and be prepared to use the re-characterization rules. These rules allow you to reverse a conversion through Oct. 15 of the following year. By then, the fate and
details of tax reform should be clear. You can re-evaluate the conversion decision. If a conversion no longer is a good idea, you can re-characterize. Simply instruct the custodian to return the converted
Roth IRA, including income and gains, to a traditional IRA. You’ll be treated as though you never made the conversion.

Keep in mind that if you re-characterize, you can redo a conversion after a waiting period. The re-conversion is allowed the later of 30 days after the re-characterization and the following calendar year. For example, if you re-characterize in December 2017, you have to wait until early 2018 to convert
again after 30 days. If you re-characterize in June 2018, you have to wait until 2019 to convert again (the following year).