Lessons Learned During This Tax Season

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. We're just through the 2018 tax season, and retirement expert Ed Slott says that there are some valuable takeaways for people who converted traditional IRAs to Roth. He is here with me today to discuss them.

Ed, thank you so much for being here.

Ed Slott: Great to be back here live at Morningstar in Chicago.

Benz: Thank you. Let's talk about some of the surprises that people had with doing conversions from traditional IRAs to Roth. One, you said, is that people were unaware that you can't reverse the conversions anymore. Let's talk about that.

Slott: Probably not Morningstar viewers because we covered this ad nauseam on many of these videos.

Benz: Right.

Slott: But it really wasn't as mainstream as you and I might have thought. And remember, we're talking about 2018 conversions. So, that's when the law hit. In 2018, Roth conversions became permanent under the Tax Cuts and Jobs Act. So, once you converted, that's it; you owe the taxes, no do-overs, no recharacterizations--that was the term we used, the tax term for meaning getting a do-over. Say, you went to your tax preparer, you are doing your taxes and you see the bill and you say, nope, I want to bring some of that back. You can't do that anymore. And some people found that out for the first time when they went to do their 2018 taxes in 2019.

Benz: And there were some people, kind of, gaming the system, right, doing conversions and then reversing them?

Slott: Lots of people. Right. And many people did large conversions. Some people converted everything and figured "I'll go back and get it right to the exact point I wanted." But that benefit, that planning strategy, wasn't available.

Benz: So, one thing you can do though still is if you make the wrong contribution type, you can still reverse that, right?

Slott: Right. That's a recharacterization of a contribution, but that's small money compared to some conversions. Remember, there's no cap on the amount you can convert. With contributions, you are talking about $6,000 or $7,000. So, yes, maybe you contributed to a Roth and you were over the income limits, you could recharacterize it to a traditional IRA if you qualify there.

Benz: So, one thing you noted is that some people actually got a happy surprise. They did conversions and found out they owed less on that conversion than they expected because they were in a lower tax bracket.

Slott: Lower tax bracket, and the new brackets--the new for 2018 that most people saw now in 2019--were bigger brackets, the 22%, the 24%; plus, some small business owners were pleasantly surprised with that qualified business income deduction of 20%. Many of them didn't figure on that. There's still a lot of confusion with that deduction, who gets it, who doesn't, income limits, and all of that. So, some people were surprised that the cost of the Roth conversion was lower than they anticipated.

Benz: On the flip side, though, there were some taxpayers who were probably caught off-guard, some things happened with their tax return, their tax filings that caused them to owe more on their conversions. Let's talk about the people who would have generally been affected by higher taxes on a conversion on the 2018 ...

Slott: Well, people that probably didn't take into account the loss of their state income tax deductions or miscellaneous itemized deductions, they may have ended up taking the larger standard deduction in lieu of the itemized deductions, which many of them were rolled back. But that larger standard deduction was not anywhere near what they used to be able to itemize, especially people with investment advisory fees, no longer deductible, a cap on state taxes, and things like that. So, in essence, it cost them more even though they in their mind may have thought, "Well, don't I get a tax cut, lower rates?" but some people got hit with that.

Benz: So, thinking about the 2019 tax year and whether conversions are advisable. It's obviously a big question, very individual-specific. But you think it will be easier for people in 2019 determining whether a conversion is a good idea than it was last year. Why is that?

Slott: Yeah. So, it will be much easier, and I highly recommend that you do a projection. It's like any big expense. If you go into a store and buy a car or furniture, you want to know what it costs upfront. It's a big expenditure. Same thing with a Roth conversion. Now, it was harder to do last year. Even people that tried projections, they were comparing one tax system in 2018 to a tax system that was nothing like that back in 2017. So, it was hard to compare apples-to-apples. But now, we have 2018 under our belts and we can compare apples-to-apples. So, what I would suggest: I might even hold off til later in the year. I still love Roth conversions if they are right for people to move money to tax-free territory, but you don't know what's going to be. So, if you wait til later in the year or do a series of smaller annual conversions to stay in the certain brackets that you have. But you really need to do a more accurate projection before you go all-in on a Roth conversion. And you don't have to convert everything.

Benz: And how can market volatility potentially play into the advisability of conversions? If your balance is depressed, that might make it more advantageous to convert?

Slott: Yeah. But it's very hard to time the market because a Roth conversion is a long-term proposition. You're doing it for long-term tax-free growth and no RMDs and all the benefits of a Roth conversion. Whether there's a spike or the market tanks a bit, you can't predict that. That's why I said, maybe do smaller annual conversions each year, wait towards the end of the year, say, til after Thanksgiving, because maybe you didn't anticipate a bonus and you have a better idea of what the tax cost will be. But it's very hard to time the market for anything, especially a Roth conversion.

Benz: And it seems like valuable advice to get some advice. If you are not super comfy with tax matters, get some tax advice.

Slott: Yeah, get a good tax projection '18 to '19.

Benz: Ed, thank you so much for being here to share your perspective.

Slott: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.