5 IRA Planning Strategies
Given the new rules, now is the time to make sure clients are making the right decisions for next year’s tax season.
How to help clients face the 2018 tax season.
Advisor investment fees are no longer deductible as an itemized deduction. Let clients know this now and discuss alternatives.
Here’s what will happen next year at tax time: Your client’s accountant will tell your client about all the tax planning that could have been done last year. But by then, it will be too late. That’s because, unfortunately, many tax preparers are history teachers. They tell you what already happened. Nobody wants to hear woulda, coulda, shoulda. How about changing this annual annoying scenario? With all the new tax law changes, every advisor should alert clients about what can be done now to help them avoid taxpayers’ remorse next year. Consider these five ideas to stay ahead of the game. 1. Roth conversions. The Tax Cuts and Jobs Act eliminated the ability to reverse or recharacterize a Roth conversion. The new rule applies to conversions done in 2018 and later years. In past years, if a Roth IRA conversion resulted in an unexpectedly high income-tax bill, or if the client simply changed his or her mind, the conversion could be reversed by recharacterizing the Roth IRA funds back to a traditional IRA. However, starting in 2018, this option no longer exists. But there’s still a shortterm recharacterization planning opportunity, if you act now. The IRS has said that 2017 Roth conversions can still be undone up to Oct. 15, 2018. However, each client needs to consider this option individually. All else being equal, a tax arbitrage strategy can work for your clients, where you reverse last year’s Roth conversion and remove the tax bill at last year’s higher rates, then replace it with a Roth conversion this year at lower tax rates. That’s OK if income is roughly the same each year. But you’ll need to look further, for example, to see what 2017’s tax bracket actually was, and how it will compare with his year’s lower and more expanded tax brackets. You’ll also have to see how well the 2017 converted funds performed. For instance, if they are up substantially, those are tax-free gains and, in that case, the conversion most likely should not be undone. Why move tax-free gains back to a taxable IRA? Also, compare the 2017
tax return with a projected 2018 tax return to see if there are any spikes or income aberrations to plan around. For example, if 2017 included a large business loss that would have made last year’s Roth conversion less costly, that conversion is worth keeping. But maybe 2018 will have large deductions or losses that would make a 2018 conversion more tax efficient, as opposed to the 2017 conversion. This reverse-and-replace strategy is a one-time opportunity that ends on the October deadline. After that, any new Roth conversion is permanent. That certainly doesn’t mean conversions should be avoided. The long-term tax-free benefits, after all, are too good to pass up. It just means clients need more planning advice when considering Roth conversions in the future. Here are three more tax-planning ideas to better project the tax bill for converting an IRA to a Roth IRA: Make the conversion late in the year when tax results for the full year can be more accurately estimated, especially given market volatility. There’s an exception to that advice. If the market takes a big dip earlier in the year, consider converting while stock prices are low. Your client may also want to consider making only a partial conversion to minimize the tax costs. A series of annual partial conversions may convert even a large IRA without pushing income into higher brackets. Have the new tax brackets available to better project next year’s tax bill. 2. Plan a qualified charitable distribution. This is one of those strategies the client will hear about only next year, when it’s too late to take advantage of a QCD for this year. As a result of the new tax law, more clients will be taking a standard deduction and their charitable gifts will no longer be deductible. But the QCD gives the client a double advantage. They can take the standard deduction and effectively add a charitable deduction on top of that, by having those gifts excluded from income. The only negative is that the provision isn’t available to more taxpayers. It applies only to pretax funds in IRAS, not company plans, and clients must be at least age 70½ at the time of the QCD. A QCD may be as large as $100,000 per person (not per IRA) and can be used to satisfy a client’s RMD requirements. QCD rules prohibit using donor-advised funds or private foundations. Because a QCD is not included in income as a distribution, tax-wise, this is better than taking a taxable IRA distribution and trying to offset it with a charitable contribution deduction. The QCD does not increase adjusted gross income as a taxable IRA distribution does. Higher AGI can be costly in several ways, for instance by increasing income tax on Social Security benefits and boosting Medicare premiums. When a client is nearing age 70½, it may make sense to delay making charitable contributions until the client becomes eligible to make use of QCDS. The tax savings can be significant. Say a client will be in the new 24% tax bracket for 2018 and makes a $10,000 gift using the QCD. If the RMD happens also to be $10,000, then none of that RMD is included in income. If the client is taking the standard deduction where no charitable contributions are deductible, this $10,000 QCD provides an effective tax deduction and will reduce the 2018 tax bill by $2,400 ($10,000 lower taxable income x 24% tax rate = $2,400 tax savings) compared with giving the old way — without the QCD. The savings are highest when the client takes the standard deduction, but due to the lower AGI limits, there are still tax savings for clients who itemize. 3. IRA fees no longer deductible. Advisor investment fees are no longer deductible as an itemized deduction. Let clients know this now and provide some alternatives, rather than have their CPA tell them next year at tax time. The bottom-line strategy here is to pay IRA fees from the IRA. This will provide an effective tax deduction, as the fees are paid from pretax funds. But never do this from the Roth IRA, as those are after-tax funds. In that case, pay the Roth fees from other taxable funds, even if there is no tax deduction available. Roth fees cannot be paid from the traditional IRA.
When a client is nearing age 70½, it may make sense to delay making charitable contributions until the client can use a QCD.
4. Anticipate taxes from the pro rata rule. The IRS aggregates all traditional IRAS, including SEP and Simple IRAS, as one when determining the tax due on distributions. This can result in a surprise tax bill if clients are unprepared, so review this issue with clients now, before doing any Roth conversions or taking other IRA distributions. As an example, to make a back-door Roth IRA contribution, Jack makes a $5,000 nondeductible contribution to a new traditional IRA and promptly converts it to a Roth IRA. All the funds in this traditional IRA are after taxes, so he expects no taxable income to result. This would be true if Jack owned only that traditional IRA. But Jack also owns another IRA holding $120,000, consisting entirely of pretax contributions and earnings. The IRS will aggregate the two IRAS and treat them as one with a balance of $125,000. Of that, $5,000, or 4%, consists of after-tax funds. Thus, Jack’s $5,000 Roth IRA conversion will produce $4,800 of taxable income. The converted funds are 96% taxable and 4% tax free, as will be any distribution from either IRA. Before making any Roth IRA conversion or IRA distribution, check the impact of the pro rata rule to avoid giving the client an incorrect estimate of the tax bill. This mistake cannot be undone because Roth recharacterizations are no longer available. 5. Plan for RMDS. Check clients’ RMD obligations and be sure they are met. Remember, there’s a whopping 50% penalty for missing one. If a client has multiple traditional IRAS, under the aggregation rules, the year’s entire RMD can be taken from any one of those accounts. This can be a way to adjust the amounts left to different beneficiaries or if the IRAS invest in different kinds of assets, to liquidate particular assets first. For a client who reaches age 70½ during 2018, the first RMD must be taken by April 1, 2019. For others, RMDS must be taken by year-end. If income will be considerably lower in 2018 than in 2019, it might pay to look at taking all or part of the first RMD in 2018. Remember, clients who inherit Roth IRAS as non-spouse beneficiaries are also subject to RMDS. In conclusion: Now is the time to help your clients plan their 2018 Ira–related tax moves and end the woulda, coulda, shoulda cycle.