Article Highlight:

  • Converting Traditional IRA Funds to a Roth IRA
  • Recharacterizations – Undoing the Conversion
  • Benefits of Recharacterizations
  • Recharacterization Timing

When you convert a traditional IRA to a Roth IRA, you have to pay the tax on the conversion.   However, individuals frequently do that this so they can take advantage of future tax-free accumulations. Distributions from Roth IRAs are generally tax free, including any earnings (accumulations) while the account is a Roth account.

Are you considering converting your traditional IRA to a Roth IRA in 2017? Are you hesitant to do so because of uncertainty about the timing and specifics of the Administration’s and Congress’ proposal to cut tax rates for individuals? Have no fear, because you can convert your traditional IRA to a Roth IRA this year, and if tax reform passes with lower tax rates effective next year, you can undo the conversion for 2017 and then re-convert for 2018.

Tax law allows individuals who convert in one year to undo that conversion by a procedure    referred to as recharacterization.   The procedure has been used for years, primarily by individuals whose IRA funds are invested in stocks and who converted from their traditional IRA funds to a Roth IRA only to see the value of their Roth IRA decline after the conversion due to stock market fluctuations. Recharacterizations are also used by individuals who converted their traditional IRA to a Roth IRA and then found they could not or did not want to pay the conversion tax.

This same process can be used by anyone for any purpose.   So, for example, if you converted your regular IRA to a Roth IRA in 2017 and tax reform is enacted effective in 2018, you can recharacterize (undo) your 2017 conversion back to a traditional IRA. However, the recharacterization must be accomplished by the extended due date of your 2017 tax return, which is October 15, 2018. If you choose to, you then can then reconvert the traditional IRA to a Roth IRA in 2018 and take advantage of the new lower tax rates.

Generally, you must wait at least 30 days to make the reconversion. However, if you make the recharacterization of the Roth IRA back to your a traditional IRA in 2017, you may not reconvert that amount from the traditional IRA to a Roth IRA before the beginning of 2018 or, if it is later, the end of the 30-day period beginning on the day on which you transferred the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.

Example: For years, Jack has been making deductible traditional IRA contributions. Then, during the summer of 2017, Jack decided to convert $25,000 of those traditional IRA funds into a Roth IRA. After the conversion is completed, late in 2017, Congress passes and the president signs a tax reform bill that reduces Jack’s marginal tax rate in 2018. To take advantage of the lower tax rate, Jack recharacterizes (undoes) the conversion back to a traditional IRA for 2017 and then reconverts it back to a Roth IRA in 2018. To do that, Jack first transfers the $25,000 (plus earnings or minus losses since the original conversion) back to a traditional IRA by way of a trustee-to-trustee transfer (it’s OK for the transfer to be with the same financial institution). He could make the recharacterization as late as October 15, 2018, but chooses to do so on January 15, 2018. Then, after making the transfer back to the traditional IRA, Jack reconverts the amount back to a Roth IRA on Feb. 20, 2018.

For more information on recharacterizations and conversions, and how they might fit into your tax planning, please give this office a call.