photo by American Advisors Group
Two years ago, Congress passed the Tax Cuts and Jobs Act, which made many sweeping changes but mainly left retirement saving alone. After stalling in the autumn, legislation to plug that gap seems set to arrive before New Year’s Day.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act will go into effect on Jan. 1, 2020, assuming President Trump signs the bill into law. It seems likely that he will, which means the SECURE Act is getting nearly overnight delivery to the American public. It will make a variety of changes to laws governing retirement accounts, especially individual retirement accounts. At least one of those changes may make the prospect of converting a traditional IRA into a Roth IRA less attractive.
Savers fund traditional IRAs with pretax dollars and owe income tax on distributions, including the earnings on the IRA investments. Roth IRA distributions are tax-free, since the accounts are funded with after-tax dollars and earnings are specifically exempted from tax. The government allows savers of any income level to convert traditional IRA assets into a Roth IRA, which is often appealing since direct contributions to a Roth IRA are only allowed for taxpayers with income below certain thresholds. However, as you might expect, Uncle Sam still gets his due. Converting a traditional IRA to a Roth IRA involves paying tax on any converted assets. If the account is large, this tax bill can be hefty. But depending on the saver’s circumstances, conversion can offer many long-term benefits, since after the one-time tax hit, assets will grow free of tax.
In recent years, lawmakers have made converting an IRA into a Roth IRA slightly more complex. After the 2017 tax reform package passed, I wrote in this space about the loss of the ability to hit “undo” on a conversion. Before the Tax Cuts and Jobs Act, savers had a window after converting to change their minds and “recharacterize” some or all of the conversion. This made IRA conversions flexible, but the 2017 reform did away with this flexibility.
Under the SECURE Act, a new conversion wrinkle arises from the loss of so-called stretch IRA rules. Previously, if you inherited a traditional IRA or a Roth IRA from someone other than your spouse, you typically had the option to spread account distributions over your lifetime. (The rules are slightly different for spouses.) Because the annual required minimum distribution for an inherited IRA was determined in part based on the beneficiary’s life expectancy, savers would often designate a young beneficiary for their retirement accounts to stretch the distributions, allowing for maximum tax-free or tax-deferred growth. Under the new law, most nonspouse beneficiaries will have to take all of an account’s required distributions within 10 years of the original owner’s death, regardless of the beneficiary’s age. (The law carves out exceptions for chronically ill and disabled beneficiaries, and provides an extra buffer for minors.)
The ability to “stretch” an inherited IRA was inarguably useful. But even if lawmakers decided all IRA assets had to come out immediately after the owner’s death, the reality is that any individual account owner should consider several variables before determining whether a Roth conversion makes sense, with the potential for transferring wealth just one among them. Beneficiaries aside, IRA conversions allow you to swap tax-inefficient assets for efficient alternatives, by using taxable funds to pay the tax on the conversion. Converted assets can then grow tax-free in the new Roth IRA. The shorter time frame for beneficiary distributions under the new law reduces the potential benefits of converting to a Roth, but it does not eliminate them.
With markets at an all-time high, retirement savers need to approach conversion strategically, especially without the safety net of recharacterization. The younger you are, and the smaller the amounts involved, the easier the decision to convert may be. This is not to say someone with a large account or someone nearing or already in retirement should never convert; they should simply bear in mind that more could go wrong. For instance, if your assets drop in value soon after you convert, you will have paid tax on asset values that you promptly lost to the market. Such an outcome can be frustrating, especially in light of the fact that you used to be able to recharacterize a conversion to avoid it.
Due to this risk, an IRA owner with a large account may prefer to convert it in pieces over time, rather than all at once. Converting gradually also can offer tax benefits, especially if you are not in the highest possible income tax bracket. Converting an IRA bit by bit allows you to convert enough in a particular year to max out the bracket you already occupy without recognizing so much income that you wind up in the tier above.
The changes the SECURE Act is set to enact will involve adjustments for savers and financial planners alike. But, at least so far, lawmakers have left conversion in place as a strategy that can offer concrete benefits, as long as savers approach it with care.