Its official: We have tax reform. But, how does it affect your IRAs, 401(k)s, 529s, Coverdells, and other retirement and education savings accounts? Let’s break down what’s new, what was proposed and didn’t make it, and what stays the same.
New Changes for 2018
There are two major changes effecting retirement, health, and education savings accounts in the bill:
1. Roth re-characterizations are dead.
Account holders will no longer be able to conduct what is known as a Roth re-characterization. A Roth re-characterization occurs when you convert from a Traditional IRA to a Roth IRA, and then later decide that you would like to go back. This helped those who couldn’t pay the tax on the conversion, or those who saw their account value go down after the conversion as they were able to undo the conversion, wait a period of time, and then reconvert and alter tax years at a lower value. The strategy will still be allowed for those who converted in 2017 and want to undo in 2018, but is unavailable after that. For my prior article outlining how the Roth re-characterization works please refer to my article here.
2. 529s can be used for K-12 private school.
College savings plans known as 529s have been expanded, and can now be used for K-12 expenses up to $10,000 per year. 529 plans remain unchanged as to college expenses, and the $10,000 cap only applies to K-12. Although you do not get a deduction for 529 plan contributions, 529 plans allow for tax-free growth and the funds can be used for education expenses. For a summary of 529 plans, and the differences between 529s and Coverdell ESAs (aka Coverdell IRAs) please refer to my prior article here.
What Was Proposed and Didn’t Make It in the Final Bill
There were a number of proposals that were part of one bill, but were removed before passing through Congress and getting signed by President Trump. These proposals include:
1. Ending Coverdell ESAs (aka Coverdell IRAs).
This proposal was part of the House bill – not included in the Senate bill – and, in the end, changes to Coverdell accounts were removed from the final bill. This is good news as Coverdell ESAs have been used by many as a means to save for their kids’ or grandchildrens’ college expenses. Similar to a 529, there is no tax deduction on contributions, but the funds grow tax-free and are used for college education expenses. The nice thing about a Coverdell, as opposed to a 529, is that you can decide what to invest the account into whether they are stocks, real estate, private companies (LLCs, LPs), or cryptocurrency.
2. Restrict deductible traditional retirement plan contributions.
There were proposals to restrict deductible traditional retirement plan contributions and to force the majority of 401(k) or other employer plan contributions to be Roth. The goal: Raise revenue now. Thankfully, these proposals never made it into the House nor Senate bills.
There were some minor hardship distribution changes for employer plans but other that the items outlined above, Tax Reform was neutral on retirement plans and savings for Americans and sometimes that’s the best you can hope for.
Are you having second-thoughts about your Roth IRA Conversion? Did the value of your IRA decrease after you converted it? Are you unable to pay the tax on the conversion? If so, you’re in luck as you can re-characterize your Roth IRA back to a traditional IRA and you can avoid the taxes due too. Given the ups and downs of investments, this may be an excellent strategy for those whose account has decreased since their conversion in 2016.
If you have converted a Traditional IRA to a Roth IRA in 2016, you can reverse the conversion by doing what is called a Roth IRA conversion re-characterization. Under a re-characterization, the Roth IRA funds and assets are rolled back into a Traditional IRA, and the amounts converted are considered contributed to the traditional IRA and you effectively cancel out the amounts converted. As a result of the re-characterization, the taxes that would have been owed for the Roth IRA conversion are no longer due, and the assets and funds re-characterized go back to a Traditional IRA.
A Roth IRA conversion re-characterization is an excellent strategy in two situations. First, if you do not have the funds to pay the taxes on the conversion. Reversing the re-characterization will remove the tax liability. Problem solved. Second, if the investments in your Roth IRA, following the conversion, did not fare so well and if the account decreased in value you are generally better off re-characterizing the conversion and going back to a traditional IRA and then conducting a new Roth IRA conversions at the lower valuation. If you have completed a Roth IRA conversion re-characterization, you do have to wait until the next year to convert the same amounts back to Roth as the IRS restricts you from immediately re-converting after a re-characterization.
Here are a few keys facts to keep in mind for Roth IRA conversion re-characterizations:
1. You must coordinate the re-conversion with your IRA custodian as they will need to roll the Roth IRA funds back to a Traditional IRA. Your tax return also needs to properly report the re-conversion so that you don’t end up paying taxes on the 1099-R you will have received for the Roth IRA conversion.
2. You can re-characterize up to October 15th of the year following the year you converted. So if you conducted a Roth IRA conversion in 2016, you have until October 15, 2017 to re-characterize the conversion. You have until October 15th even if you did not file an extension and even if you have already filed your tax return for the prior year. If you filed a tax return already and claimed the Roth IRA conversion amounts as income, the tax return will need to be amended.
3. Roth 401(k) or other employer in-plan Roth conversions cannot be re-characterized so once those are reported to the IRS you cannot reverse them as the rules applicable to Roth IRA conversion re-characterizations do not apply to 401(k) or other in-plan Roth conversions.
Because of the re-characterization rules, the decision to convert funds to a Roth IRA isn’t as “taxing” as you’d think as you can later have a change of heart if the odds don’t end up in your favor (e.g. lower investment value, or no personal funds to pay taxes on the conversion).
More details and information can be obtained from an informative FAQ page from the IRS here.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook.
It’s the end of the year and many IRA investors are stressing about what they need to do by December 31, 2016. Here’s what you need to know for your IRA as it relates to year-end.
1. 2016 Contribution Deadline. First, the good news. You don’t have to make your 2016 contributions by year-end. You have until April 18, 2017 to make your traditional IRA, Roth IRA, or SEP IRA contributions for 2016. Check out the “IRS Year-End Reminders for IRAs” here for more details.
2. Roth Conversions. If you are planning to convert traditional IRA dollars to Roth for 2016, then you must make that conversion by December 31, 2016. If you convert in 2016 (by 12/31/16), then the amount you convert will get reported on your 2016 tax return. For those that have a down year or that simply want to start down the path of moving funds from traditional (tax-deferred funds) to Roth (tax-free), you’ve got to jump on this now. Your IRA custodian will typically have a Roth Conversion form that you complete and return to them. If you are converting cash, then the process is pretty simple as the value of the conversion is the cash amount. If you have a self-directed asset such as real estate or an LLC interest, you will need an appraisal or valuation of that asset in order to convert it to Roth. And lastly, if you’re on the fence about doing a Roth conversion because you’re worried about how much it will cause you in taxes, the IRS allows you to un-do the Roth conversion later in 2017, your funds go back to traditional funds, and you don’t have to pay the tax. This is one of the few things the IRS let’s you un-wind. Check out my prior article on Roth re-characterizations here.
3. The Over 70 1/2 Club. For those over 70 1/2 with traditional IRAs, you are required to take required minimum distributions (“RMD”) from your account each year. The deadline for 2016 RMDs is December 31, 2016. There is a 50% excise tax penalty for failure to take RMDs. In other words, if you don’t distribute the money to yourself from your IRA in time, the IRS will just take half of it to penalize you. Those with Roth IRAs need not worry as Roth IRAs are exempt from RMD. I’ve explained the facts and fiction on RMDs in a prior article you can find here.
So, if you’ve got a Roth conversion or RMD to take for 2016, you better get your “IRA” in gear. If you’re wondering about IRA contributions, don’t worry, you’ve got until April 18, 2017 to make them.