By: Denise Appleby,CISP, CRC, CRPS, CRSP, APA.
The recharacterization of Roth conversion is one the few provisions under the tax code that allows taxpayers to reverse taxable transactions if they change their minds. Unfortunately, this provision has effectively been repealed. This means that you could find yourself locked into conversions that you thought you could recharacterize.
Taxpayers may convert eligible amounts from traditional IRAs, SEP IRAs, SIMPLE IRAs, and the ‘traditional’ side of employer sponsored retirement plans to Roth IRAs[1].
If you convert an amount to a Roth IRA, you are required to include any pre-tax amount of the conversion in your income, for the year in which the amount leaves the non-Roth account. An exception applies to any portion of the Roth conversion that is properly recharacterized.
Recharacterization Option
You may reverse a Roth conversion, by recharacterizing the amount to a traditional IRA. A recharacterization effectively nullifies the Roth conversion, treating it as if it never happened, for income tax purposes.
Note: Roth conversions can also be done by converting amounts from the traditional side of an employer sponsored retirement plan to a designated Roth account (DRA) – such as a Roth 401(k), under the plan. A recharacterization was never – and still is not – an option for such a conversion.
Recharacterizations can be done for full or partial conversion amounts and can be done for any reason, including if you simply changed your mind about wanting the assets to be held in a Roth IRA.
Recharacterizations are required to be completed by your tax filing due date, plus extensions, and must include any net income attributable. This means if you had a Roth conversion done in 2017, any recharacterization of that conversion must be completed by your 2017 tax filing due date. If you file your tax return return by the due date, you receive an automatic six-month extension to complete the recharacterization- generally making October 15, 2018 the recharacterizations deadline for a 2017 Roth conversion.
Change in Tax Law
In the past, you would have been able to ‘test’ the Roth waters with conversions, with the assurance that you could recharacterize those conversions by the applicable deadline, if you changed you mind. But, that is no longer the case.
Under the Tax Cuts and Jobs Act (Pub. L. No. 115-97), Roth conversions done after December 31, 2017 are not permitted to be recharacterized.
Under the new rules, any Roth conversion that you perform on January 1, 2018 and after must remain as Roth conversions, and included in your income for the year in which the assets leave your traditional retirement account.
Please make note of this change, in the event you are considering Roth conversions.
Note: You can still recharacterize a regular contribution from a Roth IRA to a traditional IRA and vice versa, as long as you meet the eligibility requirements for making a contribution to the receiving account. For example, you can recharacterize a regular contribution to a traditional IRA, only if you are under age 70 ½ in the year for which the contribution is made. For Roth IRAs, your modified adjusted gross income must not exceed certain amounts.
Roth Conversion Planning Tip
If you are unsure about whether you want to convert amounts to Roth IRAs, you could approach the strategy with caution, by converting partial balances. For example, if you want to convert $100,000, you could choose to convert that amount over several years. Analyzing the tax impact of past Roth conversions can help to determine if additional conversions should be done.
This partial conversion strategy can also be used ensure that the converted amount does not put you into a higher tax bracket. For example, if you file as single and you are in the 12% tax bracket, you could ensure that any converted amount does not result in an increase income that would put you in the 22% tax bracket or even higher. Being in a higher tax bracket means that the conversion and other taxable income would be subject to the higher tax rate.
A Roth Conversion Analysis Can Determine Suitability
Regardless of how much you choose to convert, a Roth vs traditional IRA analysis should be done before the conversion. This helps you to make an educated decision about whether a Roth account is more suitable than a traditional retirement account; by projecting how much taxes could ultimately be owed if the assets are kept in the traditional IRA account vs if the amount is converted to a Roth IRA.
Contact your Advisor
Choosing between a traditional and Roth account could be one of the most important decisions that you make with your retirement savings. But, now that you no longer have an option to recharacterize conversions, it is important more than ever to ensure that you are Roth-suitable, before performing any conversion.
If you need help with making the decision, please contact your financial/tax advisor.
[1] Qualified plan, such as 401(k) and pension plans; thrift savings plans, 403(b) plans and governmental 457(b) plans
