The Tax Cuts and Jobs Act Has Pluses and Minuses for Roth IRAs
For years, tax advisers have lectured clients about the benefits of Roth IRAs. Not much has changed after the Tax Cuts and Jobs Act (TCJA). They're still beneficial, despite a new rule that prohibits Roth conversion reversals. As always, the conversion of a traditional IRA is the quickest way to get a relatively large sum into a tax-smart Roth account. Doing a conversion before year-end could be a great tax planning strategy. Here's what your clients need to know about Roth IRAs and conversions in our post-TCJA world.
Roth IRAs Have Two Big Tax Advantages
As a tax adviser, you already know the two biggest Roth IRA advantages, but let's review.
Tax-free Withdrawals. Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free (and usually state-income-tax-free too). What is a qualified withdrawal? It's generally one that is taken after the Roth account owner has met both of the following requirements:
(1.) He or she has had at least one Roth IRA open for over five years.
(2.) He or she has reached age 59 1/2 is disabled, or is dead. [See IRC Sec. 408A(d)(2) .]
For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which the individual's initial contribution to any Roth account was made. That initial contribution can be a regular annual contribution or a conversion contribution. (See Reg. 1.408A-6, Q&A-2 .)
Example 1: Five-year rule.
Glenda opened her first Roth IRA by making a regular annual contribution on 4/15/15 for her 2014 tax year. The five-year clock started ticking on 1/1/14 (the first day of Glenda's 2014 tax year) even though she didn't actually make her initial Roth contribution until 4/15/15. Glenda will pass the five-year test on 1/1/19. She can take qualified (federal-income-tax-free) Roth IRA withdrawals any time on or after that date.
Exempt from Required Minimum Distribution Rules. Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account was originally set up) isn't burdened with the requirement to start taking Required Minimum Distributions (RMDs) at age 70 1/2. Therefore, an original account owner is free to leave the Roth account untouched for life. This important privilege makes the Roth IRA a great asset to leave to one's heirs (to the extent the account owner doesn't need the Roth IRA money to help finance retirement).
After the original account owner's death, however, the Roth beneficiaries must follow the same set of RMD rules that apply to an inherited traditional IRA that was originally owned by a person who died before the RMD beginning date. As you know, the RMD beginning date is April 1 of the year following the year the account owner turns age 70 1/2. (See Reg. 1.408A-6, Q&A-14 .) Fortunately, the RMD rules for inherited accounts can turn out to be quite favorable for a Roth IRA beneficiary. That's because the rules usually allow the beneficiary to take RMDs over his or her life expectancy. Therefore, an inherited Roth IRA can potentially continue to earn federal-income-tax-free income for many years (depending on the beneficiary's age).
Making Annual Roth IRA Contributions
The idea of making annual Roth IRA contributions makes the most sense for those who believe they will be subject to the same (or higher) tax rate during retirement. As you know, the TCJA tax rate cuts for individuals are scheduled to expire at the end of 2025, and they could be repealed sooner depending on political developments. So, it's not hard for an upper-income individual to conclude that he or she will be subject to the same (or higher) tax rate during retirement.
The downside of making annual Roth contributions is you get no deductions. If your optimistic client expects to pay lower tax rates during retirement, he or she might be better off making deductible traditional IRA contributions (assuming income permits) because the current deductions may be worth more than future tax-free withdrawals. However, if the client has maxed out on deductible retirement contribution possibilities (because income is too high), annual Roth contributions may be the way to go.
Contributions Are Limited and Earned Income Is Required. The absolute maximum amount you can contribute for any tax year to a Roth IRA is the lesser of (1) earned income for that year or (2) the annual contribution limit for that year. Basically, earned income means wage and salary income (including bonuses), alimony received that's included in gross income, and self-employment income. For 2018, the annual Roth contribution limit is $5,500 or $6,500 if the account owner is age 50 or older as of year-end. This assumes the account owner is unaffected by the phase-out rule explained later.
Key Point: These annual Roth IRA contribution limits are the same as for annual contributions to traditional IRAs.
Annual Contribution Privilege Is Phased Out at Higher Incomes. For 2018, eligibility to make annual Roth contributions is phased out if Modified Adjusted Gross Income (MAGI) is between $120,000 and $135,000 for unmarried individuals. For married joint filers, the 2018 phase-out range is between $189,000 and $199,000 of joint MAGI. For those who use married filing separate status, the 2018 phase-out range is between $0 and $10,000 of MAGI. This range is fixed by statute and isn't adjusted for inflation.
To calculate a client's MAGI, start with “regular” AGI from line 7 of the 2018 draft Form 1040. Then, add back (1) any deduction for traditional IRA contributions, (2) any Section 222 deduction for higher-education tuition and fees (in expired status as of the end of 2017), (3) any Section 221 deduction for student loan interest, (4) any Section 137 tax-free employer adoption assistance payments, (5) any Section 135 tax-free interest from U.S. savings bonds redeemed to pay higher-education costs, and (6) any Section 911 tax-free foreign earned income and housing allowances. [See IRC Secs. 408A(c)(3)(B) and 219(g)(3) .] Note that the last three add-backs aren't very common.
Annual Contribution Deadline. The deadline for making annual Roth contributions is the same as the deadline for annual traditional IRA contributions; i.e., the original due date of the return. For example, the contribution deadline for the 2018 tax year is 4/15/19. However, your client can make a 2018 contribution anytime between now and then. The sooner the client contributes, the sooner he or she can start earning tax-free income.
Older Clients Can Still Make Annual Contributions. After reaching age 70 1/2, your client can still make annual Roth IRA contributions, assuming there are no problems with the earned income limitation or the MAGI-based phase-out rule. In contrast, contributions to traditional IRAs are off limits for the year the client reaches age 70 1/2 and for all future years. [See IRC Secs. 408A(c)(4) and 219(d)(1) .]
Participation in Retirement Plans Doesn't Affect Eligibility for Annual Contributions. Eligibility to make annual Roth contributions is unaffected by the client's participation (or a spouse's participation) in a tax-favored retirement plan. In contrast, a MAGI phase-out rule restricts the right to make deductible traditional IRA contributions if either the client or a spouse participates in a plan. [See IRC Sec. 219(g).]
Roth Conversion Basics
A Roth conversion is treated as a taxable distribution from your traditional IRA because you're deemed to receive a payout from the traditional account with the money then going into the new Roth account. So, doing a conversion before year-end will trigger a bigger federal income tax bill for this year (and maybe a bigger state income tax bill too).
However, today's federal income tax rates might be the lowest your clients will ever see. Thanks to the TCJA, the rates shown in the following table apply for 2018. These brackets will be adjusted for inflation for 2019-2025. In 2026, the pre-TCJA rates and brackets are scheduled to come back into force.
If your client converts in 2018, he or she will pay today's low rates on the extra income triggered by the conversion and completely avoid the potential for higher future rates on all post-conversion income that will be earned in the new Roth account. That's because qualified Roth withdrawals taken after age 59 1/2 are totally federal-income-tax-free. As explained earlier, the best candidates for the Roth conversion strategy are people who believe that their tax rates during retirement will be the same or higher than their current tax rates.
Multiyear Conversion Strategy
Converting a traditional IRA with a relatively big balance could push you into a higher tax bracket. For example, if you're single and expect your 2018 taxable income to be about $100,000, your marginal federal income tax bracket is 24%. Converting a $100,000 traditional IRA into a Roth account in 2018 would cause most of the extra income to be taxed at 32%. However, if you spread the $100,000 conversion 50/50 over 2018 and 2019 (which you are allowed to do), the extra income from converting would be taxed at 24%.
Ill-fated Conversions in 2018 and Beyond Can't Be Reversed
For 2018 and beyond, clients can no longer reverse the conversion of a traditional IRA into a Roth account. Under prior law, they had until October 15 of the year after an ill-fated conversion to reverse it and thereby avoid the conversion tax hit. This TCJA change is permanent.
For clients whose income is too high to permit deductible annual contributions to traditional IRAs, making annual Roth contributions is a no-brainer. Also, the low current tax cost of converting, coupled with the chance to avoid higher tax rates in future years, makes the Roth conversion strategy the perfect storm. The only fly in the ointment is the loss of the conversion reversal privilege.
Subscriber Note: This Tax Action Memo was written by Tax Action Panel member William R. Bischoff, CPA of Colorado Springs, Colorado.