Taxpayers who have decided to convert a traditional IRA into a Roth IRA may be wondering if they should take the plunge now and pay tax on the conversion this year, or wait till next year when tax rates may be lower under the reform plan Congress will reportedly consider this fall. Fortunately, those sold on Roth IRAs can convert this year without worry. If rates are indeed lower next year under tax reform, they can use the recharacterize-and-reconvert strategy to shift the conversion’s tax consequences from 2017 to 2018.
Why make a substantial traditional IRA-to-Roth IRA conversion? Roth IRAs have two major advantages over traditional IRAs:
1. Distributions from traditional IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions). By contrast, Roth IRA distributions are tax-free if they are “qualified distributions,” that is, if they are made (1) after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to a Roth IRA, and (2) when the account owner is 59 1/2 years of age or older, or on account of death, disability, or for the purchase of a home by a qualified first-time homebuyer (limited to $10,000). (Code Sec. 408A(d)(2))
2. Traditional IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to commence in the year following the year in which the IRA owner attains age 70 1/2. (Qualified retirement plan participants must begin taking distributions by Apr. 1 of the year following the later of the year in which they: (a) reach age 70 1/2, or (b) retire (except for 5% owners, who are subject to the same rules as IRA owners.) By contrast, Roth IRAs aren’t subject to the lifetime RMD rules that apply to traditional IRAs (as well as individual account qualified plans). (Code Sec. 408A(c)(5))
There are other tax advantages. Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions. Qualified distributions from Roth IRAs also don’t enter into the calculation of tax owed on Social Security payments, and they have no effect on AGI-based deductions.
Paying the entrance fee. A switch from a traditional IRA (or qualified plan) to Roth IRA is not income-tax-free. Instead, it is subject to tax as if it were distributed from the traditional IRA (or qualified plan) and not recontributed to another IRA (Code Sec. 408A(d)(3)(A)(i)), but it generally isn’t subject to the 10% premature distribution tax. (Code Sec. 408A(d)(3)(A)(ii); Reg. § 1.408A-4, Q&A 7) A substantial conversion could move a taxpayer into a higher bracket and/or result in reduced tax breaks that have AGI-based phaseouts or “floors.”
Fortunately, taxpayers who switch to Roth IRAs have the unique ability to determine when to pay tax on the move—in the year of the conversion, or in the following year. And that can be a boon in the situation we’re in today when it’s not clear whether tax reform will materialize and yield lower tax rates next year.
Should Congress fail to enact tax reform, or if the reform fails to yield lower his or her 2018 marginal tax rate, a taxpayer making a Roth IRA conversion this year simply will report the transaction on his 2017 return. But if tax reform succeeds, and the taxpayer’s marginal tax rate will be lower next year than this year, the taxpayer can shift income recognition of the conversion from 2017 to 2018 through a 2-step process.
Step 1 – recharacterization. The conversion from a traditional IRA to a Roth IRA —i.e., a taxable distribution from the traditional IRA followed by a timely rollover to the Roth IRA—may be recharacterized (that is, reversed or cancelled out). (Code Sec. 408A(d)(6), Reg. § 1.408A-5, IRS Publication 590-A, 2016, pg. 29)
The recharacterization is made via a trustee-to-trustee transfer directly between financial institutions or within the same financial institution. Any recharacterized conversion (or Roth IRA rollover from a traditional IRA) will be treated as though the conversion or rollover had not occurred. Any recharacterized contribution will be treated as having been originally contributed to the second IRA, not the first IRA. The amount transferred must include related earnings or be reduced by any loss. (Instructions to Form 8606, Nondeductible IRAs, (2016), p. 4)
Ideally, a recharacterization should be made by the due date (plus extensions) of the taxpayer’s return for the affected year, and reflected on the return for that year.
However, a taxpayer can make a recharacterization even after he or she has filed his return for the year for which a conversion to a Roth IRA was made. The taxpayer can make the recharacterization within six months of the unextended due date of the return for the year in which he or she made the conversion to a Roth IRA. Thus, for example, a conversion from a traditional IRA to a Roth IRA in 2017 may be recharacterized as a contribution to a traditional IRA as late as Oct. 15, 2018. A taxpayer that wants to make a recharacterization after having filed the return for the affected year must file an amended return reflecting the transfer, and write “Filed pursuant to section 301.9100-2” on the amended return. (Instructions to Form 8606, Nondeductible IRAs, (2016), p. 4)
Step 2 – reconversion. A person who converted an amount from a traditional IRA to a Roth IRA may not only transfer the amount back to a traditional IRA in a recharacterization, but may later reconvert that amount from the traditional IRA to a Roth IRA. In this way, his or her resulting income will be fixed at the time of the reconversion.
The reconversion cannot be made before the later of:
…the beginning of the tax year following the tax year in which the amount was converted to a Roth IRA; or
…the end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by way of a recharacterization.
This timing rule applies regardless of whether the recharacterization occurs during the tax year in which the amount was converted to a Roth IRA or the following tax year. (Reg. § 1.408A-5 Q&A 9(a)(1))
RIA illustration In August, 2017, Dana converts $50,000 from a traditional IRA funded with deductible contributions to a Roth IRA. In late December of this year, Congress passes a tax reform package that will substantially reduce Dana’s marginal tax rate beginning in 2018. To shift the tax consequences of her conversion from 2017 to 2018, Dana on Jan. 18, 2018, recharacterizes her IRA-to-Roth IRA conversion. That is, she transfers $50,000 from the Roth IRA (plus earnings or minus losses since the original conversion) to a traditional IRA by way of a trustee-to-trustee transfer. Then, on Feb. 20, 2018, she reconverts the amount in the traditional IRA to a Roth IRA.
RIA observation: The recharacterize-and-reconvert strategy also yields positive results where a conversion from a traditional IRA to a Roth IRA turns out to be unwise because of market factors, for example, because the Roth IRA account has declined in value because of slump in its investment. Fortunately, the taxpayer can back out of the transaction by recharacterizing the rollover or conversion, i.e., transferring the converted amount (plus earnings, or minus losses) from the Roth IRA back to a traditional IRA via a trustee-to-trustee transfer.
RIA illustration Earlier in 2017, Jim converted a traditional IRA invested in an aggressive mutual fund to a Roth IRA invested in the same mutual fund. At that time, the traditional IRA had a $100,000 balance, all of it attributable to deductible contributions and their earnings. Because of some poor investment choices by the fund, Jim’s Roth IRA currently is worth only $75,000. To avoid paying tax on $25,000 of evaporated income, Jim can recharacterize the Roth IRA as a traditional IRA. He can then reconvert the traditional IRA into a Roth IRA invested elsewhere.