Evaluating Roth IRA Conversions After New Tax Law

Question:  I have been pondering converting my traditional IRA to a Roth IRA for many years and question whether the new tax law makes a conversion more or less beneficial?

Answer:           Roth IRAs have been part of the Internal Revenue Code for many years. Like traditional IRAs, funds held in Roth IRAs grow tax deferred until they are withdrawn from the segregated accounts in which they are maintained.  Depending upon the contributor’s income, contributions to traditional IRAs are deductible for income tax purposes and taxable when withdrawn. Contributions to Roth IRAs are not tax deductible while distributions from Roth IRAs satisfying certain timing requirements are not subject to income tax. Roth IRAs also enjoy the benefit of not being subject to the lifetime minimum distribution rules that apply to traditional IRAs. These rules require IRA owners to commence distributions from their IRAs upon attaining age 70 ½.  Post-mortem minimum distribution rules apply to both traditional and Roth IRAs and require beneficiaries of deceased IRA owners to withdraw specified portions of the IRAs each year. By foregoing the deduction for the upfront contribution, Roth IRA owners and their beneficiaries can avoid taxes on all of the appreciation in these accounts.

Individuals whose income exceeds certain thresholds are not eligible to make Roth IRA contributions. However, all owners of traditional IRAs, regardless of their income, may convert a traditional IRA to a Roth IRA. This enables the account owner to reap the Roth IRA benefits.  The cost of conversion can be steep in that the IRA owner is subject to income tax on the funds held in the owner’s traditional IRA account at the time of the conversion. This tax consequence can be mitigated in part by converting a traditional IRA account to a Roth IRA over a period of years.  This will permit the converting IRA owner to avoid paying tax on the full value of the traditional IRA all at once and possibly prevent an increase in tax brackets due to the inclusion of the converted account in taxable income over time.

The new tax law presents a mixed bag for IRA owners seeking to convert traditional IRAs to Roth IRAs. On the positive side, the decrease in income tax rates makes the cost of the conversion less onerous. Previously, the highest marginal Federal income tax rate was 39.6%. The highest marginal income tax rate under the new tax law is 37%. With the overall decrease in Federal income tax rates, a taxpayer converting a traditional IRA to a Roth IRA may pay a lesser tax cost upon the conversion. 

While the tax rate decrease may incentivize many individuals to convert Roth IRAs to traditional IRAs, the new law eliminated the recharacterization rule previously available for Roth IRA conversions. Under prior law, a taxpayer who made a Roth IRA conversion could elect, by the due date of the tax return for the year of the conversion, to recharacterize the transaction and treat the Roth IRA conversion as if it never occurred.  This recharacterization rule was frequently used in circumstances where a taxpayer converted a traditional IRA to a Roth IRA and the converted assets decreased in value following the conversion.  By timely recharacterizing the conversion, the taxpayer could avoid the undesirable consequence of paying tax on assets having values in excess of the current asset values. The recharacterization option is not available under the new law.

Converting a traditional IRA to a Roth IRA still represents a viable planning opportunity in the right circumstances.  The elimination of the recharacterization rule of course may give pause to the IRA owner seeking to reap the benefits of a Roth IRA. Although this safeguard has been eliminated, the benefits of Roth IRAs coupled with the decrease in Federal income tax rates continue to present a compelling case for Roth IRA conversions.


The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.


Related Articles

Loss Deductions on Gifted Property

Loss Deductions on Gifted Property

Question: I am contemplating giving to my daughter stock which has decreased in value below my purchase price. Is my daughter entitled to a tax loss if she sells the property?

IRA Distribution Issues for Non-Designated Beneficiaries

IRA Distribution Issues for Non-Designated Beneficiaries

Question:        My widowed father recently died and failed to designate myself nor any of my siblings as beneficiaries of his IRA. Is there an opportunity to have these funds paid out over a prolonged period of time and avoid the five-year payout period?