Tax reform efforts have moved at full speed in the past two months, and Congress has now reached agreement on a final tax reform proposal for members of both the House and Senate to vote on in the coming week. Several provisions are intended to give taxpayers more money through lower rates and enhanced deductions. But to pay for those provisions, lawmakers also took away some tax breaks that many taxpayers have used for years.
Roth IRAs are one of the most valuable tax-deferred vehicles to help you with your retirement savings, allowing for tax-free growth of after-tax savings throughout your career and beyond. Anyone with traditional IRA retirement assets can put assets into a Roth IRA through what's known as a Roth conversion. Roth conversions are still allowed under the tax reform proposal, but one valuable benefit that conversions used to offer will disappear if the measure becomes law.
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Losing your Roth do-over
Those who have money in traditional IRAs can convert all or part of their assets into a Roth IRA at will. Converted Roths get the same favorable provisions that regular Roth IRAs give you, including growth in the account that goes untaxed even after you start making withdrawals, as long as you follow fairly basic rules. The drawback with Roth conversions is that you typically have to pay income tax on the amount you convert. If you convert during 2017, then you'll have to include that amount on your 2017 tax return as income.
Taxpayers face a key challenge when they decide to do a Roth conversion. You can't be sure exactly what tax impact a conversion will have until the end of the year, when you know what other income, deductions, and other factors that determine your overall tax liability. A conversion that initially looked smart could in hindsight look like a bad move. That's why lawmakers initially established a way to let taxpayers reverse their Roth conversions. Known as recharacterization, this strategy gives you until the final due date of your tax return -- including extensions -- to get a do-over. For instance, those converting in 2017 would have until mid-October 2018 to recharacterize their Roth conversion.
It's the recharacterization provision that Congress decided to eliminate in the tax reform proposal. Starting for the 2018 tax year, the new tax law would no longer allow recharacterization. Once you converted, you'd be stuck with it no matter what happened.
Why losing Roth recharacterization matters
Roth recharacterization might not sound like a big deal, but it opened up some lucrative strategies. If the investments you converted had fallen in value since the conversion, you could recharacterize and essentially start the process over. By doing so, you'd avoid paying tax on the higher amount, and shortly thereafter, you could convert the same, now lower-priced assets and have a smaller tax bill.
In addition, recharacterization helped some taxpayers get out of a bind. If it turned out that you didn't have the money to pay the taxes resulting from the Roth conversion, then recharacterizing could help you reverse the tax liability. Those who suddenly saw themselves in a much higher tax bracket than they expected could also shift gears to avoid a larger-than-expected tax bill.
Why Roth conversions are still smart
Regardless of whether tax reform becomes law, Roth conversions still make sense if you think that current tax rates will be less than what you'll pay in retirement. If you expect your tax rate to fall in retirement, then sticking with a traditional IRA and paying the taxes when you withdraw money after you retire will generally be the smarter way to go forward.
Taxpayers will have to change their behavior, however, if Roth recharacterization disappears. Because you won't have the ability to get a do-over, you'll have to be extremely careful to make the right decision at the outset. Otherwise, you won't have the ability to change your mind and will be stuck with a financial move that you might later regret.
Keep an eye on what happens in Washington with tax reform. You might have a last-minute opportunity to do a Roth conversion in 2017 and still have the ability to recharacterize, but only by looking at what finally gets passed will you be sure what's allowed.
