1. Roth IRA conversion
The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the ability to reverse or to “recharacterize” Roth conversions performed after Dec. 31, 2017. Before TCJA, if a Roth IRA conversion resulted in an unexpectedly high income tax bill, or if the IRA owner simply changed his or her mind about converting his or her traditional IRA to a Roth IRA, , then the conversion could be reversed by recharacterizing the Roth IRA funds back to a traditional IRA. This is not the case for Roth IRA conversions performed after Dec. 31, 2017, as these conversions must remain intact and cannot be reversed.
But there is still an opportunity for anyone who performed a Roth IRA conversion during 2017 to undo or to recharacterize the conversion. The deadline for performing this recharacterization or undoing the Roth IRA conversion is October 15, 2018. This is true even if an individual has filed his or her 2017 Federal income taxes. Each individual needs to consider whether a recharacterization is in his or her best interest, resulting in a lower overall tax liability for 2017.
With that background information in mind, a tax arbitrage strategy in which a Roth conversion performed in 2017 is recharacterized before October 15, 2018 makes sense under the following conditions:
(a) An individual’s taxable income is roughly the same in 2017 and 2018;
(b) the individual’s Federal marginal tax bracket in 2017 was higher than what it will be in 2018 because of the decrease in Federal marginal tax brackets, and
(c) the investment performance of the converted funds during 2017. In particular, if the converted funds in the Roth IRA performed poorly after conversion and the value of he converted Roth IRA is down substantially, then it does make sense to undo the conversion, thereby undoing the tax liability on something that has gone down in value.
It is also important to compare the 2017 tax return with a projected 2018 ta return to see if there are any losses or income spikes to plan around. For example, if the 2017 tax return showed a large business loss that would have made the 2017 Roth IRA conversion less costly in Federal and state income taxes, then it makes sense not to undo a conversion. On the other hand, if during 2018 there are more large deductions compared to 2017) (such as deductible medical expenses) that would make a 2018 conversion more tax efficient compared to a 2017 conversion.
None of this discussion should be interpreted to say that post-Dec. 31, 2017 Roth IRA conversions should be avoided. The long-term tax-free benefits resulting from a Roth IRA conversion cannot be overstated, as well as nontaxable income distribution from Roth IRAs could result in future lower monthly Medicare Part B premiums, which depend on an individual’s gross income.
Finally, the following are three recommendations for projecting one’s tax bill when converting a traditional IRA to a Roth IRA:
(a) Perform the conversion later in the calendar year when one’s income for the full year can be more accurately estimated;
(b) the only exception to performing a conversion later in the year is when the value of a traditional IRA has gone down earlier in the year as a result of a downturn in the stock market and stock prices are lower. This means less tax should be paid at that time of the conversion; and
(c) rather than making one conversion, a traditional IRA owner may want to make a series of partial conversions. A series of annual partial conversions may allow converting a large traditional IRA without pushing the converted IRA owner into a higher tax bracket.
Spreading the conversions over two tax years should result in a lower overall tax liability. This can occur if one executes some partial conversions in December of one year and the remainder of the partial conversions in January and February and the next year. It is therefore important to have each year’s tax tables available to determine the optimum number of partial conversions to perform in each of the two years.
2. Make a qualified charitable distribution (QCD) for traditional IRA owners over age 70.5
As a result of the new tax law, more individuals will be taking the standard deduction rather than itemizing on their federal income tax returns. By taking the standard deduction rather than itemizing, this means that any charitable contribution individuals make will not be deductible. But a qualified charitable distribution (QCD) gives an individual a double advantage. The individual can take the standard deduction and effectively add a charitable deduction on top of that by having those charitable contributions excluded from income. The only negative to QCDs is that QCDs apply only to pre-taxed funds in IRAs and not to retirement plans including the TSP, the distribution must made from the traditional IRA and not from the individual, and individuals must be at least age 70.5 at the time of the QCD. A QCD may be as large as $100,000 per individual and can be used to satisfy an individual’s traditional IRA minimum required distribution (MRD).
3. IRA advisory and custodial fees are no longer deductible
Under TCJA, IRA advisory and custodial fees are no longer deductible as an itemized deduction. As an alternative and to provide an effective tax deduction, traditional IRA owners in 2018 should pay IRA fees from within the IRA. This will provide an effective tax deduction, as the fees are paid from pre-taxed funds.
4. Anticipate taxes from the “pro rata” rule
When converting a traditional IRA to a Roth IRA, the traditional IRA owner should anticipate the tax liability resulting from the conversion because of the pro rata rule. The IRS aggregates all traditional IRAs, including SEP IRAs and SIMPLE IRAs, as one IRA when determining the tax due on the conversion. As an example of a Roth IRA conversion, suppose an individual makes a $5,000 nondeductible traditional IRA contribution. The contribution to the IRA was already taxed. The individual also owns another IRA worth $95,000, consisting entirely of pre-taxed earnings. The individual expects to pay no tax on the conversion of the $5,000 contributed to the nondeductible IRA. But the IRS will aggregate the two IRAs and treat them as one IRA, with a balance of $100,000. Of the $100,000, $5,000 or five percent, consists of after-taxed funds. This means that of the $5,000 converted to a Roth IRA, five percent, or $250, will not be taxable and the other $4,750 converted will be taxable. It is therefore worthwhile to check the impact of the pro rata rule before making any Roth IRA conversion in order to get an accurate estimate of the resulting tax liability. This is especially important under TCJA as Roth IRA conversions can no longer be recharacterized, effective Jan. 1, 2018.
5. Plan for traditional IRA required minimum distributions (RMDs)
For traditional IRA owners 70.5 and older, 2018 RMDs must be taken no later than Dec. 31, 2018. There is a 50 percent IRS penalty for not taking a RMD. Some things to consider about traditional IRA RMDs:
(a) If an individual has multiple traditional IRAs, under the aggregation rules the year’s RMD can be taken from any one of those traditional IRAs;
(b) for an individual born between July 1, 1947 and June 30, 1948 and is therefore reaching age 70.5 during calendar year 2018, the first RMD must be taken by April 1, 2019. If income will be considerably lower in 2018 than in 2019, it makes sense to consider taking all or part of the first RMD in 2018, and
(c) individuals who inherit IRAs, traditional or Roth, as non-spouse beneficiaries are also subject to RMDs, no matter their age and cannot transfer their inherited IRAs into their own IRAs.