Reconversion considerations

This use of recharacterization followed by reconversion allows individuals to move the same assets from a traditional IRA to a Roth IRA and pay taxes on the reduced value of the assets at the time of reconversion.

Most individuals who recharacterize for this reason fully intend to reconvert to a Roth IRA, but they want the tax benefit associated with the reduced value of the assets. Some members of Congress viewed this use of recharacterization as inconsistent with the original purpose of recharacterization.

But now that Congress has eliminated the ability to recharacterize a Roth IRA conversion, once you convert, you have no way to reverse the transaction and are stuck with the tax consequences.

This change in the tax law eliminates the ability to recharacterize a Roth IRA conversion made on or after Jan. 1, 2018. However, the IRS has clarified that a Roth IRA conversion made in 2017 can still be recharacterized. Under current law, individuals who made a Roth IRA conversion in 2017 have until Oct. 15, 2018, to recharacterize the contribution to a traditional IRA.

Although recharacterization is no longer permitted for Roth IRA conversions, it is permissible for annual IRA contributions. Individuals can continue to use recharacterization to correct an error in making an annual IRA contribution.

For example, individuals who contribute to a Roth IRA and later discover that their income exceeds the income thresholds can recharacterize their contribution to a traditional IRA. Contributions to a Roth IRA can be recharacterized to a traditional IRA, and contributions to a traditional IRA can be recharacterized to a Roth IRA under the current recharacterization rules.

This little-noticed change in the tax-reform bill that eliminates the ability to recharacterize a Roth IRA conversion sets up a tax trap for the unwary. Individuals who convert and do not seek tax advice may not be aware of the tax impact until they file their federal tax return months later. If they converted assets and do not have the money to pay the taxes, they are now stuck with their decision and can’t reverse the transaction or the tax consequences associated with it.

However, converting to a Roth IRA offers substantial tax advantages for many investors, even after paying the taxes associated with the conversion. The change in the tax law should not dissuade credit union members from converting assets to a Roth IRA. Converting to a Roth IRA may be advantageous for credit union members who believe that their tax rate in retirement will be higher than their current tax rate, or want to avoid required minimum distributions and pass along tax-free IRA assets to their heirs.

A trusted adviser

Survey after survey affirms that members view their credit unions as trusted sources of financial information and advice, and with this new change in the tax law, members may look to their credit unions for assistance with Roth IRA conversions.

In situations where members inquire about converting to a Roth IRA, credit unions should encourage the member to seek tax advice and carefully consider the tax consequences, including any potential changes to the member’s income and the member’s ability to pay the taxes on the
conversion.

If a member cannot pay the taxes and still wants to convert, then they should seek tax advice, and may want to consider spreading out the conversion over a number of years. The member can convert a portion of the assets to a Roth IRA each year and pay taxes only on the amount of pre-tax assets that they convert each year.

DENNIS ZUEHLKE is compliance manager for Ascensus. Contact him at 608-229-1875.