Ed Slott is a certified public accountant by training, but he admits that his professional colleagues have their faults. “By nature, we are history teachers — we’ll tell you what you should have done last year, after it’s too late.”
Slott is an author and retirement expert, and one of the nation’s leading authorities on individual retirement accounts or IRAs. Right now, he sees a couple of opportunities that IRA owners should consider in light of the new U.S. tax law. But they will not be available at tax time next spring when you talk with your accountant — the window for taking action will start to close later this year.
One of those opportunities concerns new rules governing the conversion of assets from traditional to Roth IRAs.
Roths accept only post-tax dollars, and gains going forward are tax-free, assuming the distribution is made after age 59½ and the account has been held at least five years. Unlike a traditional IRA, contributions can be withdrawn at any time without penalty. And Roths usually are not subject to required minimum distributions after age 70½.
Conversions are available to anyone, but often make the most sense for higher-income retirement savers seeking to get more dollars into Roths than can be done via direct contributions. Roths are subject to the same annual contribution limits as traditional IRAs ($5,500 this year, or $6,500 if you are age 50 or older). And direct Roth contributions are also phased out for higher-income workers.
There are no limits on conversion amounts from traditional to Roth IRAs. But they come with a cost: conversions are treated as ordinary income in the year of the conversion — generating an income tax bill at your current tax rate.
The Tax Cuts and Jobs Act of 2017 (TCJA) places one new restriction on Roth conversions by eliminating recharacterizations or reversals. Under the old rules, an investor could convert a traditional IRA to a Roth, but then reverse the decision anytime before the following year’s tax return deadline. That could be advantageous, for example, if you converted $20,000 in mutual fund assets to a Roth before the end of the year, only to see the fund’s value fall to $12,000 by the following March.
The new rule applies to conversions done in 2018 and in the future — but one recharacterization opportunity remains. According to the Internal Revenue Service, 2017 Roth conversions can still be undone until Oct. 15 this year.
In the current volatile stock market, changes in a fund value might not be an easy call. But if you moved to a lower tax bracket this year due to the TCJA (or if your income simply dropped), a change in tax brackets could present a recharacterization opportunity: reverse the 2017 Roth conversion and replace it with a Roth conversion this year at lower tax rates.
Slott offers one caveat to this strategy. “If you are looking at large gains on a 2017 conversion, I wouldn’t undo it even if you pay a bit more in taxes — since the gain is tax-free.”
That point underscores a key point about Roth conversions — there is no one-size-fits-all answer. Conversions do raise a pay-now or pay-later question. They make the most sense for older retirement investors who tend to be in higher tax brackets, and a bit less for those who expect income — and tax rates — to fall in retirement. “Everyone needs to do their own analysis,” Slott said.
He offered a middle ground: make a series of smaller annual Roth conversions, working up to the top of your tax bracket. For example, a married couple with income of $100,000 is in the 22 percent tax bracket; the 24 percent bracket kicks in at $165,000. “They could convert another $60,000 without kicking themselves into the higher bracket,” he said.
For older IRA owners, the TCJA has created an incentive to use a little-known route to making charitable contributions: The Qualified Charitable Distribution (QCD).
The QCD allows IRA account holders who are at least 70½ years old to make direct donations up to $100,000 annually without first taking a distribution. The TCJA raised the standard deduction to $24,000 for married couples — and for taxpayers above age 65 it is $26,600. That means many more people will be taking the standard deduction, Slott noted, making charitable contributions more “expensive.”
The QCD donations are excluded from taxable income, which means this amount effectively is added to your $26,600 standard deduction. “Excluding something is the same as deducting,” he said.
The QCD also counts any required minimum distributions that you must take starting at age 70½. And keeping these donated dollars out of your adjusted gross income also can help avoid income tax bracket creep, and reduce taxation of Social Security benefits. It also can help avoid Medicare’s high income premium surcharges.
Mark Miller is a columnist for Reuters.