MarketWatch Retirement Weekly
Source: http://www.marketwatch.com/story/will-trumps-tax-plan-pass-consider-this-strategy-if-you-end-uppaying-less-taxes-2017-06-23
Will Trump’s Tax Plan Pass? Consider This Strategy if You End Up Paying Less Taxes
Published June 23, 2017
By Matthew Curfman
Although still in its initial stages, President Trump’s tax plan has been receiving a lot of press,
which isn’t surprising given the plan calls for the biggest individual and business cuts in American
history. Certainly, if the plan passes, or even a modified version of it, and American citizens are
“gifted” a lower tax bracket, pocketbooks will notice the difference during the plan’s lifetime.
What this move could do for the economy, however, is certainly up for debate.
With the deficit continuing to rise, and possibly making an even bigger jump due to the potential
tax plan, it’s probably fair to say that lower taxes aren’t going to be a continued way of the
future. Currently (as this is being written) the US is well over $19.9 TRILLION in debt. So, what
can you do to perhaps make the lower tax bracket work a little bit harder for you should it come
to fruition?
One strategy you might want to consider for a low tax rate year is a conversion from a traditional
IRA to a Roth IRA. Most of you are probably familiar with a Roth IRA, but for those who are not as
familiar, here is a quick breakdown:

Roth IRAs are retirement accounts made up of after-tax funds

You must meet income eligibility limits in order to contribute, but anyone with an
IRA is eligible to convert

There are no income limits to convert IRAs to Roth IRAs

Distributions are tax-free when you follow the Feds rules

Contributions can be accessed any time and for any reason, tax-free and penaltyfree (be careful as this does not include your earnings)

Roth IRAs do not have pesky required minimum distributions (RMDs)
Obviously getting funds from a traditional IRA to a Roth means that you’ll have to pay taxes now
instead of when you want to access them in the future, but this is precisely why a low tax rate
environment makes this strategy more desirable. Sure, you may pay “more” in taxes right now,
but looking at the deficit we discussed earlier, do you really think that taxes are going to be
lower years down the road? I don’t believe so. Let’s say for example, you are currently in the
33% federal bracket, but under the new proposal someone drops to the 25% federal bracket.
With a lower tax bracket and your same income, could you convert some IRA funds to Roth IRAs
and still not pay more than you are used to paying in tax?
By making a conversion to a Roth, you might have a tax hit this year, as the “increased income”
could impact things such as deductions, credits, exemptions, phase-outs, alternative minimum
tax, taxation of your Social Security benefits and premiums for Medicare Part B and Part D. If you
do convert your traditional IRA to a Roth IRA and you are already RMD age, you actually have to
take your RMD before converting as well. On the plus side, you will not have to take any more
RMDs during your lifetime from your Roth IRA. Should you have a large IRA and therefore large
RMDs, this might equal a large lifetime tax savings for you. There is a window between 59 ½ and
70 ½ where you don’t “have” to do anything with your IRA, but should you?
Just like I tell our clients – we want to focus on the forest (big picture and overall plan) and not
the trees (individual holdings and savings vehicles, etc.). The big question is whether or not a
move like this would benefit your overall plan in the long run. Should you and your advisor feel
that tax rates will be higher in the future (and the amount of funds in your account will be
higher) chances are pretty good that a Roth conversion might be a good strategy for you to
consider. By following the rules for qualified Roth IRA distributions, all your Roth IRA funds,
including the earnings, will be tax-free. Talk about a great deal! Investors and eventual retirees
should absolutely consider diversifying their tax buckets (pre-tax, after-tax and tax free) within
their portfolios if at all possible.
Being a member of Ed Slott’s Master Elite IRA Group™, I understand that things are not always as
simple and straight forward. With continual changes to tax laws and lots of different personal
scenarios, there are a ton of intricacies when it comes to Roth IRA conversions. So, let’s take
some time to delve into a few of the more common situations I’ve come across to get into more
of the nitty gritty details about conversions and best practices so that you can put them to work
for you.
Best Practices: What to Know & Avoid When It Comes to Roth Conversions
To start, did you know that if you make a mistake and decide later that maybe you shouldn’t
have completed a Roth IRA conversion you have the opportunity to essentially “un-do” it? That’s
right. Let’s say you converted your traditional IRA funds to a Roth IRA and all of your funds were
held in one investment holding. The IRA was worth $5000 when you converted it to a Roth, but 6
months later it is only worth $1000. When tax time rolls around, instead of forking out taxes on
$5000 of income (when it is only worth $1000 now) you can complete a full “recharacterization”
and have those funds put back into your traditional IRA to avoid paying those taxes. Do
remember that even if you do a full recharacterization, it still must be reported on your tax
return. Certain information, like the gross distribution reported on a 1099-R by a traditional IRA
custodian for the conversion, must be reported on your tax return no matter what.
When it comes to recharacterizations you have one date that you’ll need to keep in mind:
October 15th of the year following your conversion (or the following Monday should it fall on a
weekend). So, if you converted a Roth IRA in 2017, you have until October 15, 2018 to
recharacterize. It doesn’t matter if you converted to a Roth IRA in January, June, or December,
that all counts for 2017. If you converted in January of 2017, you have until October 2018 to
“watch” your conversion and see how it goes. This applies regardless of whether or not you
request an extension to file your 2017 tax return. It also applies regardless of whether or not you
filed your tax return on or before April 16, 2018. This is a pretty sweet deal, right? The
government is allowing you to go back on your conversion with no questions asked.
So then, what if that same conversion held two different holdings – Stock A and Stock B? Stock A
performed wonderfully and grew 15% since the conversion. But Stock B lost 50%. Your
recharacterization doesn’t have to be all or nothing. According to the tax code, you can
recharacterize all or any portion of your conversion. So, you could keep Stock A in your Roth and
send Stock B right back to a traditional IRA. Be aware though that your specific investment could
have some restrictions. For instance, if a minimum balance is required with your investment
strategy, you may no longer meet the minimum balance per account if it is split between a Roth
IRA and traditional IRA. The recommended best practice here; however, is to actually separate
your Roth conversions by investment and open up a new Roth for each individual holding when
you convert. This will make things simpler should you have to recharacterize.
Likewise, if you are going to make a conversion and already have an existing Roth IRA account,
we actually recommend that you do not convert into your existing Roth IRA. While nothing in the
tax code prevents you from doing this, we have found that this makes life a whole lot easier in
the event of a recharacterization. Most of the time, you won’t know if you are going to
recharacterize, so we agree that it’s best to play it safe and just assume that you will – open up a
new separate Roth IRA. Then if you haven’t recharacterized and are past the October 15 th
deadline, you can consolidate the Roth accounts at that time.
Be aware of the pro-rata rule if you happen to have after-tax dollars in one of your IRAs before
you go down the path of converting. The rules can be complex, but I like to use the coffee and
creamer analogy to explain this topic. Coffee = pre-tax IRA and creamer = after tax IRA. No
matter how many different IRAs you have and even if you think you are good because you kept
your after-tax IRA in a separate account all on its own. Guess what? The IRS doesn’t care that
you separated it, once you made the after-tax deposit it’s like pouring cream in your coffee and
you can’t separate them anymore. Any IRA to Roth IRA conversions are now down pro-rata
relative to your total IRA balances (including pre-tax IRAs too!)!). If your income is too high in
order to contribute directly to a Roth IRA, consider a “back-door” IRA to Roth conversion. This is
a great strategy for high income earners that still want to get money into Roth IRAs for future
retirement planning. Make a non-deductible traditional IRA contribution of $5,500 (those under
age 50). Don’t forget to file form 8606 when you do this! Let the $5,500 sit in cash or a money
market earning next to nothing on purpose until your first monthly statement is generated, then
convert your IRA to a Roth IRA. Remember, there ARE income limitations in order to be eligible
to contribute directly to Roth IRAs, but there are no income limitations to contribute to an IRA.
The only question is whether or not you can deduct the IRA contribution. Make sure you
understand the pro-rata rule completely before you go down this path, because there can be
unexpected surprises from Uncle Sam if this strategy is not handled properly.
Income limitations or not? There seems to be a lot of confusion among investors on the income
rules and if there is a difference between Roth IRA and Roth 401k rules. The answer is, yes there
is a difference. You can contribute to your employer plan (in this case I am thinking of Roth 401k)
up to the max allowed REGARDLESS of your income for the year. If you additionally decide to
make a Roth IRA contribution outside of your employer plan, you can still do this, but there are
income thresholds and phase-outs that can restrict your ability to contribute here.
For example, Mary works for XYZ company making $150,000 per year and is 47 years old. Her
husband is also 47 and is a stay at home father. She can contribute $18,000 (the 2017 IRS
maximum for a 47 year old) into her Roth 401k at work and any employer match will still be
deposited to the pre-tax side of her plan. She can also make a $5,500 Roth IRA contribution to
her personal Roth IRA because she is under the income thresholds for married filing jointly.
Better yet, her husband can also make another $5,500 Roth IRA contribution in his name!
$18,000 + $5,500 + $5,500 = $29,000 per year that be put to work in Roth accounts for future
retirement. This is a great way to expand your future tax free bucket for later in life.
Many work plans such as 401ks now allow in-plan Roth conversions, but beware! If you are not
59.5 and you convert 401k money into a Roth 401k, that is considered a distribution subject to
the early distribution penalty and you cannot re-characterize if your balance drops in the future
(like our example above).
Beneficiary Planning Tools with Roth IRAs
Did you know that a Roth IRA can be a great estate planning tool? Like a traditional IRA, a
converted Roth IRA can be stretched to beneficiaries. By not having to draw RMDs from your
Roth IRA, it can grow tax free for your beneficiaries. They could inherit more because of this
extra growth.
It’s also worth noting that Roth IRA distributions to your beneficiaries are generally income tax
free. On the other hand, traditional IRA distributions are generally taxable. If your beneficiary
takes a distribution from the inherited Roth IRA after five tax years from the year of your first
Roth IRA conversion or tax-year Roth IRA contribution to any Roth IRA, the distribution will be
completely income tax and penalty free.
If you’re looking to make things easier for those you love after your gone, you may just want to
consider the benefits of converting to a Roth IRA.
Bottom Line
With all of the ins and outs of Roth IRAs and conversions, it’s always best to consult with a
qualified advisor to help ensure you are aware of all of the pros and cons for your unique
situation. Check out www.irahelp.com if you need help finding an advisor who is highly trained
on these topics. The possibilities for a low tax rate environment sure make the idea of a Roth IRA
conversion that much sweeter, for both you and your heirs in the future. Will you capitalize on
it?
Sources:
http://www.usdebtclock.org/
http://www.nasdaq.com/article/is-trumps-tax-plan-destined-for-failure-cm793172#ixzz4hvJ9NxXI
https://www.irahelp.com/slottreport/how-grow-your-roth-account-without-growing-your-tax-bill
https://www.irahelp.com/slottreport/top-10-roth-conversion-mistakes
https://www.irahelp.com/slottreport/you-are-never-too-old-convert
https://www.irahelp.com/slottreport/3-things-you-need-know-about-roth-recharacterizations
https://www.irahelp.com/slottreport/year-end-roth-conversion-question-and-answer
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-recharacterization-of-rothrollovers-and-conversions
https://www.irahelp.com/slottreport/need-know-roth-conversions-and-pro-rata-rule
https://www.irahelp.com/slottreport/backdoor-roth-conversion
https://www.irahelp.com/slottreport/over-59-12-you-must-know-these-roth-ira-and-401k-answers