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Loss of Roth 'Mulligans' Seen as Planning Crimp

By Murray Coleman February 12, 2018

The good news is that tax reforms recently passed by Congress keep provisions allowing for money to be moved from traditional IRAs to Roth accounts, which can often prove to be even more tax-friendly for high net worth clients.

But tax-savvy advisors are staying busy in a new year reaching out to clients warning them that such conversions can no longer be reversed, or "recharacterized," if tax liabilities later turn out to be too onerous.

In the past, so-called recharacterizations of Roth conversions have acted as an important "check-and-balance" for helping clients decide whether moving money between IRAs was a good idea, points out Leon LaBrecque, managing partner of LJPR Financial Advisors in Troy, Mich., which manages nearly $800 million.

"There are a number of great benefits to shifting traditional IRA money into a Roth," he says. "The problem is timing -- clients aren’t usually going to know in concrete terms their full IRS obligations until very late in the calendar year," he says.

When recharacterizations were allowed, advisors working with a client’s CPA could recommend taking advantage of an extended window -- through mid-October of the next calendar year -- to take a "mulligan" and undo Roth conversions, notes LaBrecque, who is also a CPA.

That amounted to "frosting on the conversion cake" under the old tax regime, he suggests.

"For example, if a client brought shares of Apple and its stock price dropped quite a bit late in the year, we could work with his CPA to recharacterize his taxes and basically move those shares back to his traditional IRA," LaBrecque says.

Reversing course in many cases let many of his HNW clients save thousands of dollars by avoiding taking direct hits on their tax bills. When converting traditional IRA assets to a Roth, he explains, taxes are owed at that time as ordinary income.

Unlike with traditional IRAs, Roth account holders typically don’t have to pay taxes on any gains upon withdrawal. Also, conversions can help clients "get around" needing to take required minimum distributions each year after reaching age 70-and-a-half, LaBrecque observes.

And when someone dies, Roth assets can be left to beneficiaries essentially tax-free, he adds. "Taken on the whole, Roth conversions with the ability to recharacterize those moves nine-and-a-half months later was a huge benefit for many of our clients," LaBrecque says.

The loss of such a "do-over" will crimp and complicate Roth conversions, he predicts. "It takes away some of the planning flexibility we’ve enjoyed in the past," LaBrecque says.

He still expects many of his clients to keep using Roth conversions to redistribute their wealth.

"It’s no longer as much of a slam dunk, though," LaBrecque says. "We’re going to have to analyze these moves less in tactical terms and more strategically."

The loss of recharacterization will present more challenges to advanced planning, agrees Chris Bray, managing director of Bray Capital Advisors in Naples, Fla., which manages about $300 million.

But it’s hardiy going to prove "devastating" to clients’ future nest eggs, adds the FA who also has earned CPA credentials. "Roth conversions are going to continue to be popular tax and investment planning tools for a vast majority of our clients since they typically can’t contribute to a Roth because their adjusted gross incomes are too high," Bray says.

Chris Bray

Conversions are still a viable strategy since those high wage earners can "move at least part of their traditional IRA money to a Roth," he adds. Now, Bray sees such allocation decisions as unique to each individual situation. "As an advisor, you just can’t assume anything -- you’ve got to throw out any old rules of thumb when initially reviewing a client’s portfolio and do a deeper dive," Bray says.

Another major point he’s raising with investors is that the IRS has clarified Roth conversions for this tax season.

The nine-plus month window for reversing such moves will now be allowed with 2018 filings. "The tax cuts act wasn’t signed into law until late December, so the IRS is being forgiving -- but only for this current tax season," Bray says.