Clients will be asking you about 2019 Roth conversions as the year winds down. They’ll want to know if they should convert their IRA to a Roth IRA, how much should they convert, and most important, how much will it cost?
What will you tell them?
You’ll need to know how to accurately project the tax cost of a 2019 Roth conversion because once the conversion is done, it cannot be undone. Roth conversions can no longer be recharacterized, so once the funds are converted, the tax bill is set in stone. You have one chance to get this right for the client, so your advice better be accurate.
This should be well known by now to financial advisors, but a good chunk of taxpayers did not get that memo. Tax returns for 2018 were the first under the Tax Cuts and Jobs Act (TCJA), which among numerous other provisions eliminated the ability to reverse a Roth IRA conversion. The tax bill on many 2018 Roth conversions was not what was expected due to poor tax projections. That was understandable because it was tough to compare two different tax systems (the 2017 and 2018 tax laws). There were many parts of the 2017 tax law that were dramatically changed or eliminated in 2018. Even CPAs got caught flatfooted on this and really did not see the true tax effect until the tax return was prepared the following year, when, of course, it was too late.
This year will be a bit easier to project the tax effect of a Roth conversion since we can use the 2018 tax return to compare assuming most other income and deduction items are relatively similar. But still, there are items that continue to confound the best projections.
5 Of The Most Misunderstood Tax Effects Of Roth Conversions
These are the factors that can still throw off your 2019 tax projections. Some of these items unexpectedly increased the tax cost of the Roth conversion but some can actually reduce the tax bill, creating an opportunity to capitalize by converting more funds than might have been planned.
1. Capital Gains—This one is not new, but the larger more favorable capital gains tax brackets left some thinking that a good portion of their long-term capital gains (LTCGs) would fall under the zero percent bracket and escape taxation. Not so! This was not the case for most Roth converters because each dollar of ordinary income (like Roth conversion income, wages, interest, etc.) reduces the benefit of the zero percent capital gains rate. Under the tax law, ordinary income is taxed first using up the lower LTCG brackets. Anyone with other income besides LTCG receives little or no part of the zero percent LTCG rate, so don’t count on that for your tax projections. Of course, you can always offset these stock gains by harvesting losses. It can also pay to put off taking large gains in the same year as a Roth conversion, and instead take those gains in a future year when ordinary income might be lower, For example, if most IRA funds are converted to a Roth IRA, at age 70½ RMDs will be substantially reduced lowering taxable ordinary income, and allowing more LTCG income to fall into the lower LTCG brackets.
2. 20% QBI Deduction (Qualified Business Income)—This one first appeared on 2018 tax returns and still has tax planners baffled, but only when income exceeds the threshold limits.
The 2019 QBI Taxable Income Limits:
• $321,400 to $421,400 for married-joint
• $160,700 to $210,700 for single filers.