President Donald Trump wants to slash individual tax rates, throwing a curve at investors who had planned to convert their traditional IRAs and 401(k)s to tax-free Roth accounts.
The dilemma: convert now and pay tax at today’s rates, or wait until rates are lower and a conversion will cost less?
The decision would be easier if a tax cut were a sure thing, but it’s anyone’s guess what will happen once the tax debate begins in earnest. Trump has proposed a top individual tax bracket of 35 percent, down from 39.6 percent today, as well as rate cuts for people with smaller incomes.
[See: 7 Tips for Finding the Best Target-Date Funds to Buy.]
“It’s important to remember that Trump’s tax plan is just an opening offer to lawmakers,” says Melinda Kibler, a planner with Palisades Hudson Financial Group in Fort Lauderdale, Florida. “It is very unlikely to make it to Congress without changes, whether major or minor, and no one knows how long the legislative process will take. The president announcing his plan did not mean the end of tax environment uncertainty.”
Because tax is owed on converted sums, rate cuts could make a conversion less costly later. But what if you wait and tax rates are not cut after all?
“The downside of waiting on a Roth conversion in anticipation of a tax cut that doesn’t materialize is less time for dollars to live in a tax-free account,” says Ben Birken, a financial advisor at Woodward Financial Advisors in Chapel Hill, North Carolina.
Fortunately, investors get a second chance through a process called recharacterization.
“Recharacterization of a Roth conversion allows you to essentially take a mulligan, where you can change your mind and convert back to a traditional IRA with no consequence,” says John F. Knolle, financial planner with Saranap Wealth Advisors in Walnut Creek, California.
Roth conversions are kind of like dieting and exercise — something many investors should consider but find easy to put off. By converting a traditional IRA or traditional 401(k) into a Roth, the investor can enjoy tax-free treatment of withdrawals, while money taken from traditional accounts is taxed as income. Also, Roth investors, unlike those with traditional accounts, do not have to begin required minimum distributions after turning 70.5, so they can allow their investments to continue growing tax-free indefinitely. Roth accounts are kinder to heirs as well.
[See: 10 Long-Term Investing Strategies That Work.]
But there’s a catch: After converting, the investor must pay income tax on the sum switched to the Roth. The tax applies to all money that has not been taxed before — investment gains and contributions that were tax deductible when they were made.
The prospect of a big tax bill is so off-putting that many investors never look at the conversion option very closely. Also, it can be hard to know if a conversion will really pay off, as that depends on some unknowns like investment returns and tax rates in the future, life expectancy and how many years until withdrawals are made.
“We see most of our conversions occur when clients are going to have low taxable income,” Birken says. “We use the conversions to bring clients up to the top of the 10 or 15 percent tax bracket, if possible, with an underlying belief that any tax cuts probably aren’t going to occur (in those brackets).
As a rule of thumb, investors have been told that a conversion is most likely to pay if one will have a higher tax rate in retirement than when the conversion is done, so they pay a low conversion tax to avoid a high tax on withdrawals later.
A Trump tax cut could make a conversion cheaper but, if not reversed later, could also cut taxes on withdrawals from a traditional account.
Fortunately, tax laws give investors more than one bob at the apple, by allowing a conversion to be undone, then done again when conditions are better.
“If someone performs a Roth conversion now and tax rates go down, say, next year, the account owner could always recharacterize, effectively undoing the conversion,” Birken says. “They could then perform a second conversion in 2018 to take advantage of lower rates.”
“This option is also beneficial if the market value decreases significantly during the same time frame,” Knolle says. “You can recharacterize back to a traditional IRA and convert the now-lower market value to decrease your tax bill.”
Note that a recharacterization must be done no later than Oct. 15 of the year following the conversion. So if you converted this year you’d have until Oct. 15, 2018 to undo it — plenty of time for Washington to resolve tax matters. The new conversion could not be done until at least 30 days after the recharacterization, or until the year after the original conversion, whichever comes later.
[See: 10 Skills the Best Investors Have.]
Kibler cautions that to make a conversion work best it’s important to pay the tax without using funds from the accounts involved. Doing so would leave less in the Roth than you’d started with, a deficit that may never be made up. So a conversion should probably wait until you have enough cash elsewhere to pay the tax.
More from U.S. News
10 Tips to Boost Your IRA Balance
10 Reasons to Save for Retirement in a Roth IRA
Trump Tax Cut: Should You Convert an IRA or 401(k)? originally appeared on usnews.com
