Tax Act Tip: Change Your Roth Conversion Thinking

If you’re considering converting a traditional IRA retirement account into a Roth IRA, be aware that the Tax Cuts and Jobs Act (TCJA) signed last year now limits your ability to change your mind.

The recharacterization strategy

When you convert a traditional IRA to a Roth IRA, you have to pay tax on all the contributions you’re converting because you’re changing tax-deferred money into an after-tax contribution. This can create a situation where you get over-taxed if the investment loses value later in the year.

For example, suppose that in early 2017 you converted $100,000 from a traditional IRA into a Roth IRA. You’d owe income tax on the $100,000 you converted. Now, suppose that later in the year your Roth investment declines in value, to $80,000. That means that you still have to pay tax on an additional $20,000 of income that is now gone. Ouch!

A process to undo Roth conversions called “recharacterization” had allowed you to move the Roth IRA contributions back into a traditional IRA. Your conversion tax bill would just go away and you wouldn’t have to pay tax on money you no longer have.

Here’s the bad news: the TCJA eliminates the ability to use recharacterization on Roth conversions made after 2017. For conversions made in 2017, you can still recharacterize funds converted into a Roth IRA all the way up to the 2017 extended filing date of Oct. 15, 2018, if you get a filing extension.

Change your strategy

Because the TCJA tax bill now removes the ability to undo Roth conversions, you have to change your strategy. Here are some ideas:

1. Convert at the end of the year. Because you can no longer recharacterize your conversion, consider conversions at the end of the year. This limits the potential amount of time your investment has to possibly lose money, reducing the risk of being taxed on money you no longer have.
2. Pay taxes outside of the conversion. Remember that every conversion from a traditional to Roth IRA requires you to pay income tax. Try not to pay this tax using the retirement funds you are converting. This will not only maximize the amount you convert, it will also avoid early withdrawal penalties.
3. Convert low-risk funds first. Consider converting investments with low volatility. This will reduce the risk of having a major negative swing in their value after the conversion.
4. Use dollar cost averaging. Instead of a lump-sum conversion, stretch out the risk of a downward swing by converting smaller amounts over time.
5. Create a tax-efficient plan. The new lower tax rates in the TCJA make Roth conversions more attractive than ever. There’s an opportunity now to create a tax-efficient plan to do Roth conversions over several years. Get in touch if you’d like help with this.

The tax-free withdrawal benefit of Roth IRAs can be appealing. Just make sure you take a planned approach to your conversion strategy in light of the recent law changes.