Elimination of Roth Conversion Recharacterization
July 9th, 2018
For individuals saving for retirement, one of the things that makes a Roth IRA attractive is that the account is created and funded with post-tax dollars. This means the account owner need not pay income tax on funds when they are withdrawn in retirement. However, there are limitations on who can contribute to a Roth IRA; those with incomes that exceed limits set by the IRS are ineligible to contribute to a Roth. As a result, many people invest instead in traditional IRAs or 401(k)s.
Some people have always been eligible to convert their traditional IRAs to Roth IRAs, creating a so-called "backdoor" Roth IRA. In order to be able to convert, your income needed to be below $100,000 per year, until recently, when this cap was lifted.
Why Convert a Traditional IRA to a Roth?
There are a number of reasons you might want to convert a traditional IRA to a Roth IRA. One is that a conversion allows you to circumvent income limits that would prevent you from creating a Roth IRA. Even if you make too much to open a Roth, you can effectively do so by creating a traditional IRA, paying any taxes that would be due on the contribution, and converting it to a Roth from which withdrawals will be tax-free.
Even those who are eligible to open Roth IRAs are limited in the amount of contributions they can make to those accounts. You may only contribute $5,500 annually ($6,500 if over age 50) to your Roth IRA. These limits do not apply with a conversion.
All of this sounds pretty appealing. Who wouldn't want to take advantage of this perfectly legal way to get the benefits of of a Roth IRA? A backdoor Roth doesn't allow you to evade taxes, because you have to pay tax on the previously-untaxed contributions to your traditional IRA when you convert it to a Roth. But conversion does allow you to place significant funds into a Roth, which can then grow, and be withdrawn, without the need to pay further income tax.
That said, there are circumstances in which you may convert a traditional IRA to a Roth IRA, and then want to change it back, also known as recharacterizing it. And under the new federal tax law, that option is soon to be eliminated. Learn what the elimination of Roth conversion recharacterization could mean to you.
How the New Tax Law Eliminates Recharacterization
In December 2017, the United States Congress passed a tax reform bill that eliminated taxpayers' ability to recharacterize Roth conversions for any taxable year after 2017. As for tax year 2017, if you converted a traditional IRA to a Roth in that year, and then decided you wanted to reverse that move, you may have until October of 2018 to complete the recharacterization. To make sure this is properly executed, work with your tax professional.
Why would you want to recharacterize a Roth conversion? You might find you don't have the liquid cash available to pay the taxes you now owe as a result of the conversion. You may discover that your taxable income in retirement will be lower than you first expected, which lessens the benefit of tax-free distributions from a Roth IRA. It is also possible that additional income from the Roth IRA conversion nudged you into a higher federal tax bracket, or that the value of the investment assets in your backdoor Roth has taken a dive since the conversion date. Any of these scenarios might make it desirable to recharacterize your conversion and revert to a traditional IRA.
As noted, though, this option only exists for those conversions that took place in tax year 2017. If you make a conversion to a Roth IRA in 2018, there is no longer a "back" button you can press to undo this choice if it turns out to be a losing bet.
With all the benefits that a Roth conversion offers, does losing the ability to recharacterize even matter? Yes. Particularly if the investments that you converted declined in value after the conversion, a recharacterization served as a reboot that allowed you avoid paying income tax on the previous, higher value. Then, if you so chose, you could convert the assets to a Roth again, only this time with a lower value and a correspondingly lower tax bill. That option is now off the table.
The bottom line is that a Roth conversion offers the same benefits it did before, but the risk associated with the process is a little higher than it was previously. Don't rule out the possibility of a Roth conversion, but do make sure to consult with your tax professional before taking this now-irreversible step.
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