Advisors must also take other new tax changes into account when projecting the tax on a Roth conversion, in addition to the usual items such as the taxability of Social Security, increases in Medicare Part B and D premiums, the effect on financial aid for students, etc. Some clients will lose big state tax deductions this year (they were capped at $10,000), and the increased standard deduction may not make up for the loss. Don’t count on big casualty losses either to reduce the tax bill on a Roth conversion, unless they are in a federally declared disaster area. In addition, all of the 2% miscellaneous itemized deductions are gone.
For your business clients, check the effect a Roth conversion might have on the new 20% deduction for qualified business income (the Section 199A deduction). While these might be reasons to avoid a Roth conversion, they are only short-term blips in tax planning, because the additional taxes would only be for the year of the conversion. But these issues still need to be addressed before a client commits to a Roth conversion that can no longer be undone.
4. Check estimated taxes on RMDs (use withholding). Check to see if clients that may be new to RMDs had enough money withheld or paid in through estimated tax payments to avoid penalties. If these clients came up short on their payments, consider withholding taxes from year-end IRA distributions. The tax withheld is deemed to be paid evenly throughout the year and satisfies the estimated tax payment timing requirements.
We have done this as a regular year-end item with our RMD clients when the distribution is the main item requiring quarterly estimated tax payments. We have clients withhold the projected tax due for the year from their required distribution, and they love avoiding the quarterly estimates. Advisors should coordinate with their clients’ tax advisors to see if the IRA withholding can be used to cover other income items during the year. The reason the IRA withholding works so well is that this RMD money is not usually needed. The required minimum distribution often goes right to an investment account. So rather than write tax checks during the year, do it through IRA withholding.
Another instance where this has paid off for us is with older or infirm clients who may not be making the required estimated tax payments with the vouchers we send them. In one case, an elderly client of ours could no longer handle making the estimated tax payments and had his son take care of it. But the son was busy and would sometimes make the payments late or not at all—or lose the payment vouchers we sent. Taking withholding from the IRA distribution really helped make this easier for the family, and it eliminates penalties and additional taxes due at tax time. In some cases, we increase the withholding tax to cover not only the year’s tax liability, but also the first quarter of the next year, which means there’s no balance due by April 15th. This eases pressure on the clients.
5. Split inherited IRAs by year’s end. If your client, an IRA owner, died in 2017 and had multiple individual beneficiaries named on a beneficiary form, then they can each use their own life expectancy for calculating required minimum distributions (the stretch IRA) if the inherited IRAs are split into separate shares before the end of this year. Make sure this is done, otherwise the beneficiaries will be forever stuck using the age of the oldest beneficiary, even if they split their shares in a later year. The split must be done by the end of the year after the IRA owner’s death.
6. You should know how to time a 10% penalty exception. If any of your clients had to withdraw early from their IRAs, they may qualify for an exception to the 10% penalty. If they do, the payment qualifying for the exception must be made in the same year as the IRA (or plan) distribution. This is sometimes missed at year-end, which voids the exception and forces your clients into a 10% penalty that could have been avoided. This would likely affect those who needed the money and cannot afford that penalty on top of their tax bill.
For example, let’s say you have a client named Maria, age 52, who needs to pay a college tuition bill for her son by the end of the year. She charges the tuition on her credit card in December 2018, and then in January 2019, when the credit card bill comes in, she takes an early distribution from her IRA, thinking she qualifies for the education exception for the 10% early distribution penalty for IRAs (the education exception does not apply to company plan distributions, only IRAs). But she does not actually qualify.
Maria will still owe the 10% penalty because the payment of the tuition (charged and considered paid in December 2018) and the January 2019 IRA distribution were not in the same year.
Check to make sure that clients who took an early withdrawal that would qualify for an exception from the penalty will actually qualify and not run afoul of this “same year” rule. It may sound arcane, but there have been several tax court cases on this point where the penalty exception was lost.