The new, lower 2018 tax rates have made Roth IRA planning more valuable for your clients. These lower rates provide a limited opportunity to help some clients profit from tax-rate arbitrage by capitalizing on the spread between 2017 and 2018 tax rates.
One easy way to do this is to make a 2017 tax-deductible IRA contribution now (up until April 17), and then convert it in 2018. This gives the client a deduction at a higher rate and picks up the conversion income in 2018 at a lower rate.
But the bigger money and opportunity lies in using this same planning principle for 2017 Roth conversions. Even though the Tax Cuts and Jobs Act repealed the ability to undo a Roth conversion done after 2017, IRS recently ruled that 2017 Roth IRA conversions can still be reversed, or recharacterized, up until Oct. 15. That should be looked at for each client, since this is a one-time window.
First, check the current values of those 2017 conversions. Clients with gains may want to keep their Roth conversions since those gains are tax-free. (More: Roth IRAs turn 20)
But if there are no gains, or they are minimal, then you need to look at how much tax was paid on that conversion, because that tax was likely paid at higher tax rates, all other factors being equal. If that's the case it might pay to look at recharacterizing part or all of that 2017 Roth conversion, removing the tax liability at the higher 2017 tax rates, and then replacing them with the lower 2018 tax rates, by reconverting those same funds now in 2018.
You don't have to make this decision now, since you have until Oct. 15 to reverse that 2017 conversion, and you should probably wait it out to see how the markets have performed. The same goes for reconverting those funds or converting other IRA or 401(k) funds to a Roth. But remember that all 2018 conversions will be irrevocable. This reversal strategy will only work for 2017 Roth conversions.
To see if this reverse-and-replace strategy will work, you'll need the best estimates possible, so waiting until October will give you the time to compile better data to make that evaluation. What you are looking for is the difference in the gains so far in the funds converted in 2017, versus the tax savings by reversing that conversion at last year's rates and converting those funds at lower 2018 rates. It comes down to tax-rate arbitrage, which with a Roth conversion, you can only do this year and then never again, since the ability to reverse a Roth conversion is no more.
For example, say your client Jane converted $100,000 last year at a marginal rate of 28%.That's a conversion tax of $28,000. Now assume the market was good to Jane and that $100,000 is now worth $120,000, so that $20,000 gain is tax-free in the Roth IRA. In order for it to be worthwhile for Jane to undo that conversion, the tax savings would have to be at least $20,000, since she would be giving up $20,000 of tax-free income already in the bank, so that might not be wise. If Jane's 2018 income would be roughly the same, including a $100,000 reconversion, she might be in a 24% bracket, saving approximately only $4,000 in taxes. So here, Jane is better off keeping her 2017 Roth conversion.
But if in October (prior to the Oct. 15 recharacterization deadline), Jane's Roth funds are only worth about the same $100,000 or less, it would pay to undo that Roth conversion and then reconvert at 2018 tax rates and save about $4,000 in taxes (the four-percentage-point difference between the 28% and the 24% rates on the $100,000 conversion).
This is an overly simplified example, but it shows how you might help clients benefit tax-wise with a reverse-and-replace conversion strategy, good for one use only.