Take-Away: There were only a couple of surprises in the two Bills passed by the House and Senate with regard to retirement planning. A couple more surprises could result as the Conference Committee attempts to come up with a compromise Bill that would become the law beginning in 2018. The continuation of the stretch IRA and the disappearance of Roth recharacterizations are the two biggest surprises.

Background: The news is currently filled with the promise of tax reform. Most of the media’s focus is on the elimination of the federal estate and GST taxes and the loss of many income tax deductions in a trade-off for doubling the standard deduction amount. Less attention has been given in the press to the possible changes to retirement plans and retirement contributions. What follows are what the two Bills propose to change with regard to retirement plans.

  • No Recharacterizations: You will recall that a pre-tax regular IRA can be converted to an after-tax Roth IRA, with the up-front payment of income taxes on that conversion. The current tax law permits a ‘do-over’ if after the conversion that market value of the Roth IRA drops (no one wants to pay an income tax on phantom retirement assets that no longer exist.) A recharacterization of the after-tax Roth IRA back to the pre-tax regular IRA must take place by October 15 of the year following the conversion from the regular IRA to the Roth IRA. [Recharactizations also apply to Roth and IRA contributions, too.] Both the House Bill and the Senate Bill eliminate the ability of a taxpayer to recharacterize (and thus save income taxes) an after-tax Roth IRA back to a pre-tax regular IRA [concomitantly filing for an income tax refund.] In short, both Bills would make Roth conversions irrevocable.
  • No Rothification of Employer Plans: In early reports there was considerable anxiety about the possibility that only after-tax contributions could be made by an employee to a 401(k) plan as part of tax reform and simplification. Despite that threat (source unknown) and thus a lot of hand-wringing by 401(k) participants, neither Bill proposes only after-tax accounts for employer plan contributions. Both Bills would retain the current rules for pretax deferred contributions to retirement accounts.
  • The Death of the Stretch Apparently was Premature: Despite the Senate Finance Committee unanimously voting in August 2016 to eliminate the stretch for inherited IRAs, reducing the pay-out period down to 5 years from the IRA owner’s death, neither Bill eliminates the ability to take distributions from an inherited IRA over the designated beneficiary’s life expectancy. While the stretch may continue after tax reform, I still worry that when the real magnitude of the loss of tax revenues becomes identified, the easiest way to make up that short-fall is for Congress to eliminate the stretch option, which does not increase income taxes, but only accelerates the recognition of taxable income in inherited IRAs into a shorter period of time.
  • Medical Emergency Distributions: The Senate Bill would keep the deduction for medical expenses, while the House Bill would eliminate the income tax deduction for medical expenses incurred. If this income tax deduction is preserved, the exception to the 10% early distribution penalty from retirement accounts to pay for medical expenses would still be available to taxpayers.
  • Miscellaneous Differences: In a couple of other places the Senate Bill differs from the House Bill with regard to retirement plans. First, the Senate Bill would apply a single aggregate limit to contributions for an employee who participates in a governmental IRC 457(b) plan and elective deferrals for the same employee under an IRC 401(k) or 403(b) plan sponsored by the same employer. Also the Senate Bill would allow penalty-free distributions from retirement accounts with the ability to recontribute those funds within 3 years for victims of the 2016 Mississippi River Delta flooding (apparently a new form of ‘pork-barreling’ to benefit a handful of southern Senators’ constituents!)

Conclusion: While these are only proposals in the two Bills and as such we must await the Conference Committee’s efforts to reach compromises, if a client has engaged in a Roth conversion in 2017 it may be of interest to them if the new tax law has an effective date of January 1, 2018, and they find that they have lost the opportunity to recharacterize their Roth IRA back to a regular pre-tax IRA. Those clients might want to consider recharacterizing their Roth, if the circumstances warrant, prior to December 31, 2017 as a protective measure.