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Roth Conversions Can Add Great Value, If Done the Right Way

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Roth Conversions Can Add Great Value, If Done the Right Way
October 1, 2018

With the lowering of marginal income tax rates, the new tax law is actually reducing the cost for investors who decide to convert traditional IRA assets to a Roth IRA. This move may actually save money under the Tax Cuts and Jobs Act, however, this law also eliminated the possibility of changing your mind. The process of reversing a Roth conversion, or recharacterizing the conversion, was repealed under tax reform and requires much more thoughtful analysis now going forward.

No More Recharacterization For Conversions

While Roth IRA contributions can still be recharacterized, a conversion of traditional IRA assets to a Roth IRA CANNOT be recharacterized. In the past, some taxpayers recharacterized the transaction if they decided the tax liability was too high or if it triggered other tax issues such as the taxation of Social Security benefits or the exposure to the 3.8% Medicare surtax on investment income. Others would simply undo the conversion if the Roth IRA ended up declining in value. For example, if a taxpayer converted a $75,000 IRA that declined in value to $60,000, there would not be an advantage in realizing the $75,000 in income for an account that has lost value. Now without this ability to recharacterize conversions, much more thought needs to be put into a Roth conversion before pulling the trigger.

Lower Taxes Equate To Savings

For many taxpayers, the amount of taxes they would have to pay on a Roth IRA conversion has declined. For example, for a married filing jointly taxpayer with $100,000 of taxable income, they would owe $12,500 on a $50,000 conversion based on old tax rates but today would owe $11,000 ultimately saving them $1,500 on the conversion. If taxable income is $200,000 they would owe $14,832 under old tax rates, however, today would owe $12,000 on that same $50,000 conversion.

When To Do A Conversion

Prior to tax reform, it made sense for taxpayers to convert IRA assets early in the year to maximize the amount of time before the tax filing deadline and to determine whether to undo the conversion. Also, with the option to recharacterize the entire conversion or a portion, IRA owners were able to estimate how much to convert without being fully committed to that amount. Now it may make sense to wait until the end of the calendar year. This provides more time for taxpayers to fully understand what their taxable income will look like and the consequences of adding more income from a Roth IRA conversion.

The decision to convert can be complex, depending on the potential for overall tax rates to increase (or decrease) in the future, and a taxpayer’s likely tax bracket in retirement and ability to pay the conversion tax with non-retirement funds. With any tax planning strategy, it is important to discuss the impact of an IRA conversion on your overall financial plan with a qualified tax professional.

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