On December 22, 2017, President Trump signed into law H.R. 1, known as the Tax Cuts and Jobs Act (the “Act”), which makes widespread changes to the Internal Revenue Code (the “Code”). Among other things, the Act eliminates the ability to undo a Roth IRA conversion by a recharacterization. This change could have a significant impact on your financial planning and how you manage your Roth IRA.
Impact on your IRA retirement planning
With sweeping tax cuts, investors and advisors may be looking for new solutions to better plan for retirement. The good thing is that even though the tax law changed some aspects of Roth IRAs, they still could be a powerful solution in self-directed IRA tax planning.
Among the changes the Act includes are changes to what has long been called the Backdoor Roth IRA. Historically, a Roth IRA’s strict income caps has made it off limits for many high-income individuals to contribute directly to a Roth. However, there’s a popular workaround that investors have used to sidestep the IRS rules and restrictions through a “backdoor” approach – by opening a Traditional IRA, making your annual contribution (up to the federal limit) and then later converting the funds to a Roth IRA. Congress has confirmed this is a legal strategy.
Prior to the Act, an investor could opt to undo a Roth conversion by recharacterizing the funds back to a Traditional IRA. There are several reasons for doing this, but most often when the market price or fair market value of an investment drops to the point that the tax liability from the Roth conversion would be greater than you anticipate having to pay in the future. It’s a common strategy to undo the Roth conversion with the intent to convert at a later time to take advantage of the market value adjustment.
Now that the Act eliminates this undo (recharacterization) option, it’s important to carefully consider a Roth conversion and the tax risks.
Benefits of a Roth IRA with alternative investment categories
Contributions in a Roth IRA are made with after-tax dollars and therefore are not tax-deductible. This means that if you ever withdraw from the account, the funds and earnings will be tax-free as long as it’s been five years and you’ve reached age 59½. In contrast, contributions to a Traditional IRA are tax-deductible. The amount is taken from before-tax income, so if you ever withdraw from that account, taxes would be owed on that amount.
A Roth IRA has benefits that are very attractive—and can be considered for alternative investment categories. All qualified distributions from a Roth IRA are tax-free. This cannot be overstated enough, especially important in retirement and with alternative investments. Some alternative investments like private equity and debt, may generate large income distributions or may offer tremendous upside in growth. A Roth can help defer taxes on the gains.
It’s important to be aware of the tax setbacks that a backdoor Roth strategy may bring and discuss with your financial planning and tax professionals.
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