Congress has eliminated the ability to reverse a Roth individual retirement account (IRA) conversion—known as a recharacterization—as part of the recently passed tax-reform bill.
As a result, IRA owners who made a Roth IRA conversion contribution on or after Jan. 1, 2018, and later suffer buyers’ remorse will no longer be able to reverse the transaction and the tax consequences associated with it.
A Roth IRA conversion allows you to convert traditional IRA assets to a Roth IRA or roll over employer-sponsored retirement plan assets to a Roth IRA. You pay taxes on all pre-tax assets that you convert—but not the 10% early-distribution penalty tax—regardless of your age at the time of conversion. Once you convert, you have the advantage of tax-free growth in a Roth IRA, and you will avoid required minimum distributions during your lifetime—allowing you to pass along tax-free IRA assets to your heirs.
Important decisions
The advantages make Roth IRA conversions attractive, but investors often have a difficult time deciding whether to convert, because they are unable to determine the tax impact of the conversion until long after the transaction occurs. Any number of events during the year of conversion, including the sale of securities, purchase of a home, new job, or a salary increase can affect taxable income.
A Roth IRA conversion transaction early in the year that looked manageable from a taxation standpoint may become unaffordable by tax time.
Investors who underestimate the cost of the conversion often discover at tax time that they do not have the money to pay the taxes on the conversion. Congress recognized this when it created the ability to convert assets to a Roth IRA, and created recharacterization as a way to reverse the transaction and the tax outcome that it creates. In other words, if you are unpleasantly surprised at tax time and want to change your mind, you get a “do-over.”
While it may not have been Congress’ intention, recharacterization also is used by individuals as a way to reduce the cost of a Roth IRA conversion in cases where the value of the converted assets declines sharply after the conversion.
An individual who converted assets to a Roth IRA, only to see the value of the assets decline substantially, can recharacterize the transaction up to Oct. 15 of the year following the year of conversion. After a mandatory waiting period, the individual can then reconvert the assets to a Roth IRA, and pay taxes based on the lower value of the assets at the time of the reconversion.
For example, if an individual converted $100,000 in pre-tax traditional IRA assets to a Roth IRA, and the value of the converted assets fell to $50,000, the individual could recharacterize the assets back to the traditional IRA.
If, after the waiting period, the recharacterized assets are worth $60,000, and the individual reconverts the assets to a Roth IRA, the individual will pay taxes on $60,000, the value of the assets at time of reconversion, rather than $100,000, the value of the assets at the time of the original conversion.
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