As it’s being hashed out, the new tax bill contains an unexpected and not widely publicized provision: The repeal of the Roth conversion do-over, also known as a Roth recharacterization.

This marks the end of the so-called Roth conversion cycle where funds could be converted to a Roth IRA, and then all or any part of that conversion could be undone or recharacterized.

Revenue from a 3.8% surcharge on investment profit incurred by high-earning taxpayers could be lower than previous estimates, according to the Joint Committee on Taxation.
Bloomberg News

As a reminder, here’s how a Roth conversion cycle usually works under current tax law.

  • First, there’s a Roth conversion, in which the client converts a traditional IRA into a Roth IRA and pays income tax on the amount converted.
  • If the value of the converted funds declined or there was a change in the client’s financial circumstances, however, they may have wanted to reverse the conversion. Current tax law allowed for a recharacterization, or reversal of the conversion up to October 15 of the year following the conversion. It was one of the rare second chances or do-overs allowed in the tax code.
  • Then, after a time limit, those same funds could be re-converted to the Roth. This “cycle” allowed clients to maximize the value of the Roth conversion well after the fact.

The new tax law eliminates the ability to recharacterize a Roth conversion, so going forward Roth conversions will be permanent, even though the true income for the year may not be known by year-end.

Congress seems to believe that many taxpayers were using the recharacterization to game the system, moving in and out of the Roth IRA using certain investment strategies. But I have found that the reason some clients wanted to undo their Roth conversion was usually due to a change in their circumstances like a job loss, big medical bill or other expenses they did not see coming. The recharacterization gave them the flexibility to change their mind for a limited time. Now that window has closed for good.

Personally, I think this was an overreaction and there were bigger fish to fry when it comes to closing loopholes. But this is what we have and you’ll need to act on this now.

ADVISORS NEED TO CONTACT CLIENTS NOW
Advisors need to contact every client who did a Roth conversion in 2017, especially if it was on your recommendation. You probably told them — and rightfully so at the time — that they had until October 15, 2018 to undo any part or all of that conversion for any reason, even if they simply changed their mind and no longer wished to pay the tax on the conversion.

The new law repeals the Roth recharacterization after 2017, which effectively means that any 2017 Roth recharacterizations must be completed by the end of this year, or your clients will be stuck with the tax bill.

Some of those following this legislation have commented that this repeal may only be for 2018 Roth conversions, so in that case you would still have until October 15, 2018 to undo a 2017 Roth conversion. I don’t see it that way and wouldn’t risk taking that position with a client. The provision states that recharacterizations are repealed after this year, meaning that the recharacterization option no longer exists in 2018. Even if this is not perfectly clear yet, I still would not take a chance. Advisors should protect clients and assume that recharacterizations of 2017 Roth conversions will no longer be available after year-end.

WHY ROTH CONVERSIONS ARE STILL VALUABLE
The Roth conversion may have been a good move, especially with the stock market run-up making those Roth gains tax free.

But some clients may have converted funds figuring they’d wait until next October to make the decision of how much of that conversion they want to keep and pay taxes on. Their plan may have been to convert more and then dial it back once their actual 2017 tax bracket was known. In other words, the plan was to not pay tax on the full conversion, only a part of it.

Or you might have clients who converted different types of investments to separate Roth IRAs, planning to use the recharacterization to keep the winners and undo the losers. That decision must be made by year-end now.

That’s why advisors must contact all clients who have done 2017 Roth conversions to let them know that those conversions cannot be undone after year-end. Clients will not be happy if they find this out next year from their tax accountant who has to give them the bad news that they are stuck with the tax bill, when the last thing they heard from you was that they had until October 15, 2018 to make that call.

Be proactive and make the calls to affected clients and then document that contact so it’s on the record that you alerted them to this last-minute tax law change.

Going forward, all Roth conversions will require careful professional advice since they will be irrevocable. But don’t let that keep clients away from benefitting from a Roth conversion. That’s why they need you.

Roth conversions are still valuable in that they move retirement money to tax-free territory, and Roth IRAs have no required minimum distributions after 70 ½, which allows the Roth funds to keep growing tax free if not needed. That’s a big long-term benefit.

Maybe a better strategy going forward will be to do smaller, more affordable Roth conversions over many years to gradually shift IRA funds to tax-free Roth IRAs at minimal tax cost. It also may be best to do future conversions near year-end when the ability to pay the tax will be better known.

A FEW OTHER TAX LAW CHANGES THAT AFFECT 2017 ROTH CONVERSIONS
Beginning in 2018, the new tax law may eliminate some tax deductions your clients have been taking in the past, including deductions for state and local taxes, heavy medical expenses and work-related costs. See if clients may be able to accelerate some of these deductions by taking them now in 2017, so they won’t be totally lost in 2018.

Here’s the playbook for year-end. Check to see if it would pay to do last-minute 2017 Roth conversions, and use these deductions to offset some of the Roth conversion income. Do the same thing if you have any clients with big casualty losses that can still be deducted this year. Many of those deductions may be cut back next year under the tax bill, so use them now to reduce the tax on Roth conversions or additional IRA distributions.

Obviously each client has a different situation, but this is all about connecting with clients now and letting them know that you are on the case and advising them how to react before the year ends and some of these opportunities disappear.

New tax rules are always an opportunity to showcase your value as a trusted advisor. Be proactive and protect your clients now.