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A Retirement Planning Opportunity Goes Away

The tax code doesn’t allow for many do-overs, as a rule. Now one of the best-known has vanished, thanks to the recently passed tax reform legislation.

Since 2010, the government has permitted taxpayers at any income level to convert traditional individual retirement accounts into Roth IRAs. Retirement savers fund traditional IRAs with before-tax dollars and pay tax on distributions; savers make Roth IRA contributions with after-tax dollars, and distributions are typically tax-free. Also, taxpayers needn’t take annual minimum distributions from Roth IRAs after reaching age 70½, as is the case with traditional IRAs.

These characteristics can make Roth IRAs appealing, but affluent savers did not always have access to them. The ability to convert gave taxpayers and their advisers the power to decide on the best strategy for a given individual’s portfolio.

When retirement savers perform a Roth conversion, they generally must pay tax on the full amount of assets converted in the year it happens. For a large account, that can result in a hefty tax bill – but also a hefty reward, if the account holder is able to convert sufficient future investment growth into tax-free income.

This brings us to the do-over provision. Until the new tax law passed, Roth IRA conversions were reversible, at least to a point. Savers could reverse all or part of a conversion, or “recharacterize” it, until October 15 of the following year. A taxpayer could use that window to compute his or her actual income and deductions, which would determine the real tax cost of the conversion, and adjust accordingly.

Recharacterization offered several benefits. First, if the value of the account’s assets declined substantially after the conversion, recharacterization allowed the account owner a do-over, so he or she would not have to pay tax on asset value that was lost to market downturns. Second, converting a large IRA can sometimes push the account holder into a higher tax bracket. Partially recharacterizing the IRA could keep the taxpayer in his or her original bracket; the taxpayer could then convert all or part of the IRA again the following tax year.

Both of these strategies were completely legitimate under the existing tax regime, but certain lawmakers suspected that taxpayers were “gaming” the Roth conversion system. So while the new law still permits conversions, the ability to undo a conversion is gone.

Although the change is frustrating, it does not mean that Roth conversions are no longer useful. It simply means savers will need to approach them with an understanding that there is a smaller margin of error for the unknown.

For instance, for clients with large traditional IRAs, I have often implemented full conversions each year and then done partial (or full) recharacterizations the following year to prevent the clients from being pushed into a higher tax bracket. However, going forward in these situations, we will have to do smaller conversions using conservative assumptions, with the understanding that any conversions are irrevocable.

Roth conversions will remain appealing to some, especially in a relatively low income tax rate environment. Conversion removes the uncertainty of higher tax rates in the future at the price of paying the tax in the present. For some savers, that will be a trade-off worth making. But it may make sense to wait until later in the tax year to perform conversions, since the later a taxpayer waits, the clearer his or her overall tax picture will become. And retirement savers may want to do a series of small conversions over several years instead of converting a large IRA all at once, now that there is no going back.

Overall, this change will mean retirement savers will need to take a more conservative approach when deciding whether to commit to a full or partial Roth IRA conversion in a given year. They should be sure that they are confident they will be able to pay the resulting tax bill if they convert, and they will need to understand that the taxes are a sunk cost – even if the assets lose value in the future, they will still have to pay tax on the amount they converted.

Advisers and retirement savers will eventually adjust to the new normal. But all the same, Congress has taken away a beneficial mechanism for getting the most bang for your retirement buck.

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