The new tax proposal from Congress had a November surprise. The proposal includes a repeal of the Roth IRA recharacterization, which is the ability to undo a Roth conversion. I normally don't like to advise planning based on proposed law, but this is a big deal! Advisers need to take action and get the word out now.
Under current law, when someone does a Roth conversion, they have until Oct. 15 of the following year to undo part or all of that conversion for any reason at all and remove the tax bill – a Roth recharacterization. That encouraged more Roth conversions, knowing that they could be undone after the fact, for a limited time.
That at least gave the client a limited window to know the actual tax cost of the conversion because all the income and deductions were known. After that window closes, the conversion would be irrevocable.
Apparently, this bothers Congress. They believe people have been "gaming" the system. I have not found that. There are other reasons that clients might want to recharacterize their Roth conversion. They might have lost their job, they may have incurred unforeseen medical or other expenses, or they just don't have the money they thought they would to pay the tax.
Nonetheless, if this becomes law, the recharacterization repeal will be effective after 2017. That may be true even if the law is not passed until early 2018. It still might contain this repeal effective Dec. 31, leaving people without the option they thought they had when they converted.
While recharacterization is most commonly used to undo Roth IRA conversions, it also applies to contributions too. This option too could be lost after Dec. 31.
Advisers must immediately identify and contact all clients that have done 2017 Roth conversions and warn them, as a protective measure, that if they are thinking about undoing all or any part of that 2017 conversion, they'd better get it done by year end.
These clients were rightfully advised that they had until Oct. 15, 2018, to make this decision, but that date may be effectively changed to Dec. 31, 2017. The last thing you want is for a client to request a recharacterization next year only to be told that the option no longer exists and they are stuck with the tax bill.
You may have clients that converted everything, thinking that they would recharacterize a part of that large conversion to fit their tax situation when all their actual 2017 amounts were known. That won't be the case if this becomes law.
This new tax proposal makes future Roth conversions an irrevocable decision.
This does not mean to avoid advising Roth conversions. It means that the client needs to know there is no going back. Advisers still need to look at the long-term planning benefits of Roth conversions. Clients pay tax now, but end up with an income tax free retirement account.
That is still a big benefit in that it removes the uncertainty of what future higher tax rates could do to their retirement savings. Also, it still pays to convert while tax rates are low, so don't let a change deter clients who may benefit from doing Roth conversions.
But given the potential shift, it's probably best not to do Roth conversions until much later in the year when the client's financial position for that year becomes clearer, unless the client is sure that the money will be there to pay the tax.
If this becomes law, it may be wiser to have clients do smaller conversions over the years so they are more likely to be able to pay the taxes.
Advisers will need to more carefully document the Roth conversion discussions so that clients understand that their Roth conversion cannot be undone. Contact your Roth conversion clients now. With no do-over option available, clients will need the help of a professional adviser more than ever!