I’ve written previously about the benefits of Roth accounts, due to their flexibility before retirement, and tax diversification benefits later on in retirement. With the implementation of the new tax reform, there are additional planning opportunities for individuals to convert existing pre-tax retirement money into after-tax Roth money.
An overlooked aspect of the tax reform is that the personal income tax rates for individuals are set to “sunset” in 2025, meaning they are set to revert to the previous higher rates. This is contrary to the corporate tax rate, which is set to remain at the new lower rate indefinitely. Therefore, Roth conversions are essential “on-sale” for the next 7 years, while the personal income tax rates remain at the lower level.
In the past, to be able to convert from a Traditional to a Roth IRA your income needed to be under $100,000. The IRS rules have since changed, and there is no longer an income cap in place. With the cap removed, high-income earners can now convert as long as they pay the appropriate tax on the conversion. There is no 10% early withdrawal penalty if the funds move from a Traditional IRA to a Roth IRA within a 60-day window.
If you’re someone with little to no after-tax retirement savings, I would strongly consider converting some pre-tax retirement money into a Roth IRA. The downside is that you’ll have a tax liability in the year of the conversion. This tax can be withheld from the converted amount, but if your savings and cash flow permit, it’s best to pay the tax separately so that you can maximize the amount that’s moved into the Roth IRA.
Another potential downside and caveat to keep in mind with Roth money is the risk of changes to tax legislation. With the rise in national debt, some speculate congress may one day come after Roth IRA’s as a potential source of tax revenue. I HIGHLY doubt any changes would affect existing Roth money, as any attempt to essentially double tax money without grandfathering prior contributions would be political suicide. However, I can envision congress eliminating future Roth contributions, which makes taking advantage of conversions/contributions today even more worthwhile.
Whether you’re looking to take advantage of the temporary lower personal tax rates, or just expect to be in a low tax bracket for the coming year, consider the benefits of converting Traditional IRA money to a Roth IRA. For individuals who are planning a work sabbatical, or are transitioning into retirement, you may be able to convert substantial pre-tax money with little to no tax liability. Make sure to consult a tax professional when evaluating your situation.
Although the Tax Cuts and Jobs Act made Roth Conversions more attractive because of the lower income tax rates, they also removed the ability to recharacterize the conversion, meaning if you do the conversion you cannot undo it.
Some reasons you would want to undo the conversion or “recharacterize”, would be if you ended up in a higher tax bracket than expected, or the converted amount dropped in value because of market performance, and you, therefore, were paying taxes on a higher amount than you had converted.
So if you do consider a Roth conversion in 2018 and moving forward, it’s best to either wait until the end of the calendar year so that you have a better idea of your tax situation, or if you’re worried about poor market timing, make multiple conversions throughout the year to essentially “dollar-cost average” your conversions.
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