Tax Law Changes Eliminate Recharacterizations of Roth IRA Conversions

Roth IRA conversions allow you to move some or all of the funds from your traditional IRA account into a Roth account. If you’re going to convert, you must do so by December 31st of the tax-reporting year. And, as you know, that deadline is coming up for 2018, so if you want to convert, now is the time. But, take note: tax law changes regarding these transactions no longer allow recharacterizations of Roth IRA conversions set up after 2017.

Why convert to a Roth IRA?

  • Roth IRAs are one of the most beneficial retirement plans available.
  • Contributions are made after taxes, allowing for tax-free distributions in retirement.
  • There are no required minimum distributions, so funds in the account have a longer period of time for growth.

If you meet the income eligibility requirements, you may establish a Roth. However, if you own an established IRA (traditional, SEP, SIMPLE) or 401(k), you have the option to convert some or all funds from that plan into a Roth account—whether you meet the income requirements or not.

In the past, many people have taken advantage of this opportunity. The fact that these transactions could be recharacterized sweetened the deal: If your financial situation changed during the year, you could pop your funds back into a traditional IRA or similar account to relieve your income tax burden.

However, conversion to a Roth IRA is a taxable transaction. And, the taxes on the conversion cannot be paid by the retirement account. You are personally taxed on the conversion and it is categorized as ordinary income in the year the conversion is made. Depending on your financial status, that tax could be quite hefty.

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Why recharacterizations of Roth IRA conversions were used. (Keeping in mind it’s no longer allowed.)

  • Your account may have decreased in value after the conversion
  • The conversion tax bill may be too high
  • If a recharacterization could push you into a lower tax bracket

Now, we bullet-pointed the reasons you might want to recharacterize so that you can take all of those points into account as much as you can—before you decide to convert. Because, thanks to the new tax act, recharacterizations of Roth IRA conversions after 2017 are no longer allowed. In fact, October 15, 2018, was the deadline to recharacterize conversions performed in 2017. 

Make sure a Roth conversion is the right move for you.

In the past, Roth conversions were done early in the year with the understanding that as your financial situation played out, recharacterization of Roth IRA conversions could limit your tax liability. Now that the option is gone, it is critical to try to accurately project what your financial situation will be by the end of the year. You don’t want to end up with a larger tax burden than necessary. So, if the benefits of a conversion don’t outweigh the potential risks—play it safe.

Your Takeaway

Ask yourself these questions:

  • Does a Roth IRA better suit my needs than a traditional IRA or other plan?
  • Will paying taxes now be better (cheaper) than paying them later?
  • Should I convert part or the entire amount in my traditional IRA to a Roth IRA?

The answers obviously depend on your unique situation. Consider your current income and compare your tax bracket today to your expected tax bracket/rate in retirement. How close to retirement you are also comes into play. We strongly encourage you to consult with a trusted CPA or tax advisor to help determine if a Roth IRA conversion is the best move for you. But, don’t wait too long. The deadline for 2018 to convert funds to a Roth IRA is December 31st. Many people don’t see their CPA until January or February and by then, you’re unable to perform a conversion.

If you have questions regarding this article, contact Advanta IRA today. We can be reached at 800.425.0653.

Additional reading:

Your Complete Guide to the 2018 Tax Changes

About Jack Callahan

Jack proudly earned his bachelor’s degree in finance and multinational business from Florida State University and his law degree from the University of Florida College of Law. He established Advanta IRA in 2003 and has steadily nurtured and grown the company and the team every year since. Prior to founding Advanta IRA, Jack delivered specialized counsel to real estate investors, small business owners, and real estate professionals on tax, legal and financial matters. As an industry expert, Jack is a frequent speaker on self-directed retirement plans. He is an accredited continuing education instructor for the Florida and Georgia Bar Associations, Florida and Georgia Real Estate Commissions, and The American Institute of Certified Public Accountants.