Retirement savers have long been advised to consider converting traditional IRAs and 401(k)s into tax-free Roth versions, but with the year-end deadline looming the decision has become trickier because of a rule change.
Under the tax law enacted late last year, a conversion done this year or later can no longer be reversed with a so-called recharacterization. Loss of this do-over option makes the decision to convert all the more critical.
To further complicate the issue, the hot stock market of recent years has increased the potential tax bill from a conversion, which requires that tax be paid today to avoid tax on funds withdrawn from the Roth in retirement.
At the same time, the new tax law gave many retirement investors lower tax brackets, reducing tax on a conversion and muddying the waters even more.
So how do you decide what to do?
“We have new tax rates, tax brackets, new standard deductions, lost exemptions and new AMT rules,” says Jennifer E. Myers, president of SageVest Wealth Management in McLean, Virginia. “It’s a different ball game that requires detailed planning to avoid unintended tax consequences.”
“We’ve had clients ask us about conversions over the past several months and for many it makes sense to explore the opportunity,” says Derek Bostian, a planner with Two Waters Wealth in Huntersville, North Carolina.
Among those who should be weighing their options are investors a few years from 70½, when those with traditional retirement accounts must start paying tax on required minimum distributions, he says. The issue is especially urgent for investors who may be in higher tax brackets then than now. They can pay tax today to avoid a bigger tax later.
Experts also note that today’s low income tax rates may not last if a future Congress decides higher rates are the only way to curb ballooning budget deficits.
Traditional IRAs and 401(k)s offer a tax deferral on investment gains until money is withdrawn after age 59½. And 401(k)s, and many IRAs, also provide a tax deduction on contributions. These breaks leave more money in the account to compound. But federal income tax is charged on withdrawal of any funds not taxed before — deductible contributions and investment gains.
Roths offer no deduction on contributions but charge no tax on withdrawals. Investors who meet certain income requirements can open Roth accounts and put in up to $5,500 a year, or $6,500 if older than 50. Also, investors at any income level can convert some or all of their traditional IRAs and 401(k)s into Roths to avoid those taxes on withdrawals.
But there’s a catch — money that hasn’t been taxed before is taxed as income the year of the conversion. An investor in the 20 percent tax bracket could therefore pay $20,000 on a $100,000 conversion.
The conversion would make sense anyway if it allowed the investor to avoid a bigger tax on retirement withdrawals. If the account grew to $200,000, it might be worth paying that $20,000 now to avoid a $40,000 tax later.
Of course, that $20,000 could be invested instead, and might then grow to offset the future $40,000 saving if things went well, so the decision to convert has never been a slam dunk.
It hinges on a variety of factors such as the years to retirement, investment returns, inflation and tax rates at the time of the conversion and when withdrawals will be made.
[Read: Happy 20th Birthday, Roth IRA.]
Since some of these factors are unpredictable, investors tend to convert only when most indicators flash green. Generally, conversions make sense when there are many years to retirement, allowing investments to grow enough to offset the conversion tax, when investment returns are expected to be strong, and when the investor expects to be in a higher tax bracket in retirement than when the converson is done. All that makes the future tax saving greater than the tax cost at the time of the conversion.
It can also pay to convert in a year when the traditional account is at a low point, minimizing the conversion tax. In that case gains from a rebound in the Roth will be tax-free.
Investors who convert only to see their account lose value afterward have been allowed to reverse the decision, escaping the tax bill while leaving open the chance to convert again when account value or their tax bracket is lower. But this option, available since Roths were established in 1997, was eliminated by the Tax Cuts and Jobs Act of 2017, passed November 2017.
“This is a huge change because it affects the way every client must analyze their situation when deciding whether conversion is the right move for them,” says Gary Scheer, founder of Retirement Financial Advisors in Morristown, New Jersey.
“Now it is an irrevocable decision. In the past we used to say if you weren’t sure go ahead and convert because you could recharacterize. Now we can no longer say that and clients must be very sure that conversion is right for them because there are no more do overs.”
Myers notes the news is not all bad.
“On a positive note, new lower tax rates and higher standard deductions could make conversions more tax friendly to more people,” Myers says. “This is particularly true for individuals in lower tax brackets who stand to benefit from new higher standard deductions.”
Since conversions must be done by the end of the year rather than the next April, the deadline for many retirement-plan actions, time is running out for a conversion in the 2018 tax year.
“Due to the recent tax overhaul, it can be advantageous for people in lower tax brackets or who suspect to be in higher tax brackets for the foreseeable future, to complete a Roth conversion,” says Levi Sanchez, co-founder of Millennial Wealth in Seattle.
On the plus side, income tax brackets are lower this year than in recent years. “Lower tax rates make conversion more attractive than ever,” Sheer says, cautioning that the new tax law provides for higher personal income tax rates in the future.
Many brokerages and mutual fund companies have calculators for evaluating the conversion option. Search for “Roth conversion calculator” and play with inputs like returns and tax rates
“Generally, those who will benefit the most from conversion are those who have outside funds to pay the tax bill and a long time frame to work with to accrue tax-free earnings in their Roth IRA” Sheer says.
Paying the tax with funds from the traditional account will reduce the Roth account’s starting value so much that it may never recover.
“The biggest regrets will be from those who did not get good advice and did not carefully consider the conversion decision,” he says. “Now with recharacterization gone, they will have no recourse.”
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