Rethinking the Roth IRA
Elimination of recharacterizations creates new tax considerations.
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.
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.
NEXT: 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
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.