This tax season was the first under the new tax law, the Tax Cuts and Jobs Act. Roth conversions were one of many areas where the actual impact of the changes was seen firsthand as 2018 tax returns were prepared.
Here are five items that surprised clients (and some advisers, too) about 2018 Roth conversions:
1. No recharacterizations. Most professional advisers were well aware that the TCJA eliminated the ability to undo a Roth conversion (a Roth conversion recharacterization), but unfortunately, many clients did not get that memo.
We've heard many stories from financial advisers whose clients wanted to undo part or all of their 2018 Roth conversions, mainly as a result of the market declines near year-end. As of this writing, many of those accounts have rebounded, so clients may still be OK for the most part. But some clients just didn't have the funds to pay the tax bill, thinking they could reverse some of that conversion this year.
Advisers need to do more to emphasize that Roth conversions are permanent. Once the conversion is completed, the taxes will be owed.
2. Lower tax bill. Some clients were happily surprised about the lower-than-expected tax cost of the conversion, due to generally lower tax rates and larger brackets for the lower rates. Advisers should be exploiting the 22% and 24% tax brackets to make sure they are taking advantage of the wide income range of those brackets. Since Roth conversions are permanent, advisers will need to make more accurate tax projections so they can have an idea of how much a client can convert and still remain in the lower tax brackets.
3. QBI deduction effect. Many business-owner clients enjoyed seeing the new deduction for qualified business income. The 20% QBI deduction (aka the Section 199A deduction) for clients with pass-through businesses such as partnerships, LLCs, S Corps and sole proprietorships made its debut on 2018 tax returns. Many clients qualified by being under the QBI income limits and found that the QBI deduction dramatically reduced the tax bite on their Roth conversion.
Advisers should factor that in when planning for 2019, so that maybe more IRA funds can be converted at a lower bracket. In some cases, the added income from the Roth conversion actually increased the QBI deduction for those clients who would have otherwise had lower taxable income which would have limited the QBI deduction to 20% of taxable income. In some other cases, where there were larger conversions, the increased Roth conversion income brought clients' income over the QBI income threshold resulting in a loss of the QBI deduction and a higher tax on the Roth conversion.
This is fertile planning ground for financial advisers with business clients. Now that you have seen the actual effect of the QBI deduction, take steps to plan Roth conversions to maximize that deduction for future years.
4. Underestimating the loss of tax deductions. Under the TCJA, some clients lost out on big tax deductions, mainly for state and local income taxes, or SALT deductions as they are known, as well as deductions for investment fees. These have been replaced with a larger standard deduction, but for some clients, the deductions lost far exceeded what they received in return through the standard deduction.
More clients than ever before claimed the standard deduction, which also replaced deductions for charity and medical expenses, if they were not high enough to itemize. The net effect for these clients was an increased tax cost for their Roth conversions.
5. Back-door Roth conversions. More clients whose income was too high to qualify for a Roth IRA contribution used the so-called "back-door Roth conversion" process in which they contributed to a nondeductible traditional IRA and then converted those funds to a Roth IRA. With the TCJA, both Congress and IRS have confirmed that this is an allowable strategy, which makes advisers more comfortable recommending it.
Now that the true effect of the TCJA has been revealed with actual amounts, planning can be done with greater precision for 2019 taxes.