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Roth Conversions and Recharacterizations

 

Roth Conversions and Recharacterizations

Roth IRAs can provide a significant tax benefit to taxpayers. While contributions to such plans are not tax deductible, distributions from the plan, including accumulated earnings, can generally be taken out tax free if the amounts have been held in the plan for at least five years. The tax-free nature of such distributions can reduce the taxable amount of social security benefits and reduce the impact of income-sensitive thresholds on the recipient’s income tax return. In addition, while a traditional IRA requires the taxpayer to take minimum distributions starting at age 70 ½, a Roth IRA has no such requirement. Thus, if funds are not required by the IRA owner, the owner’s beneficiaries can receive the remaining balance in the account on an income-tax-free basis as well.

Unfortunately, higher-income taxpayers cannot take direct advantage of Roth IRAs because of income limitations preventing their use. However, a special workaround rule allows such higher-income taxpayers to first make a contribution to a traditional IRA and then convert/roll over that amount to a Roth IRA, basically achieving the same result as a direct contribution to a Roth IRA. Note that the full balance of a traditional IRA, not just current-year contributions to the traditional IRA, can be converted to a Roth IRA. To the extent that the fair market value of the converted IRA exceeds the taxpayer’s basis, that excess is taxable income in the year of conversion, but the 10% penalty on early distributions does not apply.

Prior to the TCJA, a taxpayer who had made a conversion from a traditional IRA to a Roth IRA had until the due date, including extensions, of their return for the tax year of the conversion to change their mind and undo that conversion, which is known as a recharacterization. A taxpayer may want to undo the conversion if the value of the converted account dropped significantly after the conversion or if they suddenly found themselves in a higher-than-expected tax bracket in the year of conversion.

The TCJA does not repeal the special workaround rule that allowed a taxpayer to contribute to a traditional IRA and then convert to a Roth IRA, but it does repeal the use of the recharacterization rule to subsequently unwind such a conversion that occurs on or after January 1, 2018. However, the IRS has clarified that a Roth IRA conversion that was made in 2017 can still be recharacterized back to a contribution to a traditional IRA if the recharacterization occurs by October 15, 2018.

Roth conversions for higher-income taxpayers remain a highly valuable financial planning tool, despite the inability to undo such conversions. Taxpayers who have not yet explored this tool with their tax or financial advisor should definitely have a conversation to see if they would benefit.

Author(s)

Christenson_Crystal
Crystal Christenson, CPA, MST
Partner
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