Recharacterization is off the Table

posted by Bil Lako - 1.30.18

William G. Lako, Jr., CFP®
Principal, Henssler Financial

One provision in the new tax reform law is quite applicable to your financial planning. For tax years beginning after Dec. 31, 2017, the Tax Cuts and Jobs Act repealed the option to recharacterize a Roth conversion. It has effectively made Roth IRA conversions irrevocable. For example, let’s say you converted a fully pre-tax traditional IRA worth $100,000 to a Roth IRA in 2018. Further, assume that your Roth IRA is now worth only $60,000. Unfortunately, now you’ll owe federal and state income tax on $100,000, even though the current value of those assets is only $60,000.

Prior to the repeal, recharacterization was one of the few “do-overs” you could get under the tax code. If you convert funds from a pre-tax Traditional IRA to a Roth IRA, it is a taxable event. You will owe taxes at your current marginal rate on the amount converted. Generally, we recommend investors pay the tax on the conversion with money outside of the IRA to avoid any early withdrawal penalties. The deadline to recharacterize a conversion made in 2017 is October 15, 2018, the deadline for individual tax returns. If the investors chose to recharacterize, the conversion was treated as if it never happened for tax purposes. For conversions made in 2018 and onward, recharacterization is not an option.

“Prior to the repeal, recharacterization was one of the few “do-overs” you could get under the tax code”

This “do-over” helped investors who may have rushed into a conversion without fully understanding the tax impact of the decision. A recharacterization could also help investors avoid paying income tax on IRA assets that have lost value since the conversion. Others may have unexpected expenses during the year, which ate into the funds the investors would have otherwise used to pay the taxes due on the conversion. Regardless the reasons, recharacterization allowed investors to control their tax situation.

An important aspect to note is that Roth conversions are not off the table. Investors are still allowed to convert their Traditional IRA to a Roth IRA, opting to pay the taxes due now on the assets. With lower marginal tax brackets and the increased alternative minimum tax threshold that the Tax Cuts and Jobs Act brought, investors still have a golden opportunity to convert funds from a Traditional IRA to a Roth without being pushed into a higher tax bracket because of additional income from the conversion. However, taxpayers may want to wait until closer to the end of the year when they are more certain of their income and deductions for the year.

Once the assets are in a Roth IRA, earnings grow tax-free, and distributions are often tax-free after age 59 ½. Furthermore, Roth IRAs are not subject to mandatory distribution requirements during the life of the owner. While no one can predict tax rates in the future, most investors will be better off having tax-free withdrawal options in retirement. Another advantage of a Roth IRA is when the account holder intends for the Roth IRA to be left to heirs. Heirs must pay income taxes on withdrawals from an inherited Traditional IRA, but if they properly opt for a lifetime income stream from an inherited Roth IRA they won’t have to pay income tax on the money as they withdraw it.

The bottom line is that if you are choosing to do a Roth conversion, you need to have a very clear understanding of the tax implications of doing so. The conversion is a permanent decision, and the tax implications can be further complicated if your IRA is a mix of pre-tax funds and nondeductible contributions. You cannot pick and choose which funds to convert. Instead, the amount you convert is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.

William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a Certified Financial Planner™ professional.