Larry Light: Why would someone want to make this switch?
Bruce Bell: Let’s first go over some IRA basics. Roth IRAs have been part of the Internal Revenue Code for many years.
Like traditional IRAs, funds held in Roth IRAs grow tax deferred until they are withdrawn.
Depending upon the contributor’s income, contributions to traditional IRAs are deductible for income tax purposes and taxable when withdrawn.
Contributions to Roth IRAs are not tax deductible while distributions from Roth IRAs satisfying certain timing requirements are not subject to income tax.
Roth IRAs also enjoy the benefit of not being subject to the lifetime minimum distribution rules that apply to traditional IRAs. These rules require IRA owners to commence distributions from their IRAs upon attaining age 70½.
Post-mortem minimum distribution rules apply to both traditional and Roth IRAs and require beneficiaries of deceased IRA owners to withdraw specified portions of the IRAs each year.
By foregoing the deduction for the upfront contribution, Roth IRA owners and their beneficiaries can avoid taxes on all of the appreciation in these accounts.
Light: What are the mechanics of conversion?
Bell: Individuals whose income exceeds certain thresholds are not eligible to make Roth IRA contributions.
However, all owners of traditional IRAs, regardless of their income, may convert a traditional IRA to a Roth IRA. This enables the account owner to reap the Roth IRA benefits.
The cost of conversion can be steep in that the IRA owner is subject to income tax on the funds held in the owner’s traditional IRA account at the time of the conversion.
This tax consequence can be mitigated in part by converting a traditional IRA account to a Roth IRA over a period of years.
This will permit the converting IRA owner to avoid paying tax on the full value of the traditional IRA all at once and possibly prevent an increase in tax brackets due to the inclusion of the converted account in taxable income over time.
Light: How does the recently enacted tax reform affect a conversion to a Roth?
Bell: The new tax law presents a mixed bag for IRA owners seeking to convert traditional IRAs to Roth IRAs. On the positive side, the decrease in income tax rates makes the cost of the conversion less onerous. Previously, the highest marginal federal income tax rate was 39.6%.
The highest marginal income tax rate under the new tax law is 37%. With the overall decrease in federal income tax rates, a taxpayer converting a traditional IRA to a Roth IRA may pay a lesser tax cost upon the conversion.
Light: And on the negative side?
Bell: While the tax rate decrease may incentivize many individuals to convert Roth IRAs to traditional IRAs, the new law eliminated the re-characterization rule previously available for Roth IRA conversions. Let me explain.
Under prior law, a taxpayer who made a Roth IRA conversion could elect, by the due date of the tax return for the year of the conversion, to re-characterize the transaction and treat the Roth IRA conversion as if it never occurred.
This re-characterization rule was frequently used in circumstances where a taxpayer converted a traditional IRA to a Roth IRA and the converted assets decreased in value following the conversion.
By timely re-characterizing the conversion, the taxpayer could avoid the undesirable consequence of paying tax on assets having values in excess of the current asset values.
The re-characterization option is not available under the new law.
Light: What’s the bottom line?
Bell: Converting a traditional IRA to a Roth IRA still represents a viable planning opportunity in the right circumstances.
The elimination of the re-characterization rule of course may give pause to the IRA owner seeking to reap the benefits of a Roth IRA.
Although this safeguard has been eliminated, the benefits of Roth IRAs coupled with the decrease in federal income tax rates continue to present a compelling case for Roth IRA conversions.