The 2019 tax season that concluded a few weeks ago, in which 2018 Federal income tax returns were prepared and filed, was the first tax season that occurred after passage of the Tax Cuts and Jobs Act of 2017 (TCJA). TCJA’s passage resulted in numerous individual tax law changes, one of which was in the area of Roth IRA conversions. This column discusses four lessons related to Roth IRA conversions taking place during 2018 that many Federal employees and Uniformed Services members and their tax advisors learned and that all individuals who are considering funding their Roth IRAs in 2019 should keep in mind.
- Recharacterizations on Roth IRA conversions are no longer permitted, but recharacterizations on Roth IRA contributions are still permitted. Starting Jan. 1, 2010, any individual – no matter the individual’s income, age, or filing status – can convert an existing traditional IRA to a Roth IRA. Although the traditional IRA owner has to pay income tax on the conversion, for many traditional IRA owners who are ineligible to contribute to a Roth IRA (because their incomes exceeded the limit for contributing to a Roth IRA), a Roth IRA conversion is an alternative means of obtaining a Roth IRA. But if after converting, the traditional IRA owner decides that the Roth IRA conversion was not a wise move for a variety of reasons (for example, the owner could not afford to pay the taxes due on the conversion or the value of the IRA converted was decreasing and the owner was paying taxes on something that had decreased in value), then the owner can “recharacterize” the conversion. “Recharacterization” simply means that the conversion is “undone” and, provided the recharacterization was performed before the owner filed his or her income taxes for the year the IRA was converted, the owner will owe no taxes. But TCJA eliminated the recharacterization option, effective with all conversions performed after Dec. 31, 2017.
Unfortunately, many individuals did not get the information concerning the repeal of Roth IRA conversions and recharacterizations. Employees and Uniformed Service members should be aware that under TCJA, effective Jan. 1, 2018 once a conversion is performed, it is permanent and cannot be “undone”. Nevertheless, if an individual contributes to a Roth IRA and discovers later in the year that his or her income is too large for that year to allow for a Roth IRA contribution, then the individual is still permitted under the TCJA to recharacterize the Roth IRA contribution as a nondeductible, traditional IRA contribution. The individual has until the filing deadline he or she files their Federal income tax return for that year. In making a nondeductible IRA contribution, the individual needs to file IRS Form 8606 (Nondeductible IRAs) with his or her federal tax return.
- 2. Does a Roth IRA conversion make sense given the lower Federal individual tax rates under TCJA? Some individuals were pleasantly surprised when they converted their traditional IRAs during 2018 and paid lower than expected Federal income tax. This was a result of generally lower individual tax rates under TCJA. But since Roth IRA conversions are permanent, individuals and their tax advisors are encouraged to make projections of income in 2019 to ensure that if they make a Roth IRA conversion during 2019, that the additional income associated with a conversion will not push them into a higher individual tax bracket. In particular, since most Federal employees and Uniformed Service members were in the 22 percent or 24 percent marginal tax bracket in 2018, these individuals should make sure that in performing conversions in 2019, that the additional income resulting from a Roth IRA conversion does not push them into a 30 percent or higher tax bracket. Tax professionals can advise individuals how much they can “safely” convert without ending up paying more taxes. Individuals also need to consider the effect of Roth IRA conversions on their state and local tax liability if they convert.
- Under TCJA, several “big” tax deductions were limited or lost, and this could affect the tax liability resulting from a Roth IRA conversion. As mentioned previously, a Roth IRA conversion will likely result in additional taxable income in the year of conversion. The amount of taxable income will be determined by the size of the traditional IRA being converted (the larger the size of the traditional IRA, more assets to be converted and more gross income) and by offsetting deductions that reduce the gross income. These offsetting deductions include state and local income taxes and real estate taxes, as well as deductions for investment fees for individuals who itemize (file Schedule A on their federal income taxes). But under the TCJA, some individuals lost a portion of their state and local income taxes and real estate taxes (limited to a total of $10,000) and investment fees that are no longer deductible. In the place of reduced itemized deductions was a larger standard deduction for all filing categories. Even with a larger standard deduction, for many individuals, the deductions lost far exceed what they received in return through the increased standard deduction. The overall result is that some individual Roth IRA owners who perform conversions under TCJA will pay more taxes compared to Roth IRA owners who performed Roth IRA conversions pre-TCJA, even with the decrease of individual tax rates under TCJA.
- “Back-door” Roth IRA conversions are still possible under TCJA. One strategy that has been frequently used since 2010 by individuals whose income was too large to allow Roth IRA contributions is a “back-door” Roth conversion process. With a “back-door” Roth IRA, an individual contributes to a nondeductible traditional IRA (limited to individuals under age 70 with earned income) and then immediately converts the nondeductible traditional IRA to a Roth IRA, resulting in little, if any, tax liability. With the TCJA, Congress and the IRS have confirmed this is an allowable strategy.
With these four lessons in mind and the TCJA in effect through 2025, hopefully, Federal employees and Uniformed Services members can obtain their Roth IRAs over the next few years in some manner and in so doing, pay the least amount of Federal and state income taxes.
*** Written by Edward A. Zurndorfer, who is a Certified Financial Planner™, Chartered Financial Consultant, Chartered Life Underwriter, Certified Employee Benefits Specialist and Enrolled Agent in Silver Spring, MD. He is the owner of EZ Accounting and Financial Services, an accounting, tax preparation, and financial planning firm also located in Silver Spring, MD. He is a seminar speaker at Federal employee retirement seminars throughout the country for the National Institute of Transition Planning, Inc. He is also a weekly columnist for MyFederalRetirement.com. Raymond James is not affiliated with and does not endorse the opinions or services of FEDZONE or Edward A. Zurndorfer or any of the above listed organizations. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer and/or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Telephone number, 301-681-1652.
NEW TAX LAW