Roth Conversions in 2018: Benefits and Challenges

Jack and Maggie are a couple of clients of mine who live here in Falmouth.  A very nice young couple in their late 30’s and early 40’s with a couple young kids.  They are both high earners and dedicated savers.  They were concerned about the new tax law and how that would impact not only their personal income tax, but Roth contributions and conversions, not just now but in the future.

So, this week I would like to take some time and share with you our discussion discussed since many of you may be in the same situation.

Personal income tax is dropping for many of us this year thanks to the Tax Cut and Jobs Act.   The Tax Cut and Jobs Act, signed by President Trump in December, among other things, keeps seven personal income tax brackets but realigns them slightly and lowers the rates in most brackets.  As a result, many of us find ourselves subject to more favorable tax rates than we were in 2017.  Understandably, you may ask whether taxes will go up again in the future. I don’t have a crystal ball, but if experience is any teacher chances are good, they will.

With that uncertainty hanging over our heads, it may be wise to consider converting some of your retirement assets from a tax-deferred account (like a traditional IRA) to a Roth IRA.  Roth conversions aren’t suitable for every investor, but under some circumstances, they can make a lot of sense.

Roth IRAs differ from traditional tax-deferred accounts because any contributions you make are subject to income tax, in that you do not get a deduction for those contributions on your tax return.  But when you reach retirement age, you can withdraw from your Roth account tax-free. Also, Roth IRAs are excluded from the IRS’s Required Minimum Distribution (RMD) rules that kick into play for traditional IRAs once you reach age 70 ½. What’s more, investors can continue to add to Roth IRAs regardless of age.

For all of the reasons listed above, Roth IRAs can be a lot of sense.  However, wage earners are subject to annual contribution limits and some are prohibited from contributing at all if their income exceeds certain limits (for 2018, the modified adjusted gross income limit for individuals is $135,000, for couples filing jointly it’s $199,000). Roth IRA conversions are popular with individuals and couples whose income exceeds the Roth IRA income limits.  This is because conversions don’t count as contributions, and are therefore not subject to those limits.  And while income tax is due on any amounts converted, there is no 10% early withdrawal penalty if you are younger than age 59 ½, provided you complete the conversion within 60 days.

You see, 2018 brings us a new opportunity if you’ve been considering a Roth conversion because the tax rates applied to the amount converted will likely be less this year than last year, as explained above.  However, if considering a Roth conversion, you must also ask yourself whether you will potentially be subject to even less tax in the future.  Although we can guess that rates may go up again in the future, it is possible that your personal taxable income may drop, putting you in a lower bracket.  Perhaps you are close to retirement and in another couple of years, you will no longer be receiving a salary – in that situation it may be advisable to wait.

When considering a conversion, you also want to make sure that the additional income included on your tax return (as a result of funds being converted) will not push you into a higher Medicare premium, if you are already receiving Medicare or just a couple years away from that.

If you have done the analysis and you are still thinking that a Roth conversion is the right move for you, make sure to think about how you are going to pay the tax that results from it.  In most situations, it is not advisable to pay for the conversion using the assets you are converting.  The benefit you receive from the conversion, will likely not outweigh the disadvantage of spending that tax-deferred retirement money today to pay the taxes.

Another thing to consider is that it may make sense to spread out the tax burden of a Roth conversion over multiple years. One strategy is to convert just enough each year to stay within whatever income tax bracket you would be in if not doing a Roth conversion.

Liquidity comes into play here as well. If you think you might need access to the Roth IRA funds within five years, a conversion may not be the right move. Roth IRAs have a “five-year rule” that says five years must have passed since the tax year of your first Roth IRA contribution before you can withdraw those earnings tax-free.

One last thing to think about is that market volatility after a Roth conversion can create a less than desirable result.  For example, if your IRA is worth $100,000 when you complete the conversion, but by the end of the year, it is worth only $60,000, you will still need to report $100,000 of income on your tax return.  Who would want to do that?

Cutter Family Finance readers, you have heard me say it before, to build a successful financial system, you must understand and accept the risk associated with your investment strategy.  This is one more example of why that is so important.

Under the old rules, you had until October 15th of the year following your conversion to recharacterize it. But the Tax Cut and Jobs Act changed that rule.  Going forward, you can no longer recharacterize a Roth IRA conversion back to a traditional IRA.  However, investors who converted in 2017 still have until October 15th, 2018 to recharacterize theirs.

Each investor’s tax situation is unique. But if you think your income tax burden will be the same or higher in your retirement, converting to a Roth IRA now may be a good decision for you.  By doing so, you will be taxed on those funds while you’re still in a lower bracket.  If you have years to go before retirement, converting can also work out to your advantage by subjecting a smaller amount of money to income tax, before it has grown.

It’s still early in the year, so you may want to wait to decide whether a Roth conversion makes sense for you this year.   By waiting, you may have a clearer idea of what your income will look like for the year. Waiting also gives you time to figure out the best strategy to pay for the Roth conversion when it’s time to pull the trigger.

Folks, Roth IRA conversions can be complicated, so make sure to consult your retirement specialist before proceeding.

Be vigilant and stay alert, because you deserve more!

Have a great week.

Jeff Cutter, CPA/PFS is President at Cutter Financial Group, LLC.  A wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@old.cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

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