Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

29-Aug-18

Roth IRA Recharacterization Reminder

Take-Away: The 2017 Tax Act eliminated the ability to recharacterize a converted Roth IRA back into a regular IRA, effective January 1, 2018. However, Roth IRA conversions done in 2017 can still be recharacterized ‘back’ to a traditional IRA if that recharacterization occurs before October 15, 2018. Since a Roth IRA recharacterization takes time to implement, e.g.  communicate with and among IRA custodians and physically transfer the assets (from the Roth IRA back to the traditional IRA) conversations Roth IRA owners about their need and ability to recharacterize an IRA should take place with clients at this time.

October 15, 2018 Deadline: The ability to unwind a Roth IRA conversion ended with the 2017 Tax Act. As such, the last time a Roth IRA can be converted ‘back’ to a traditional IRA is no later than October 15, 2018.

Conversion v. Contribution: While the ability to recharacterize a converted Roth IRA ends on October 15, 2018, an annual contribution to a Roth IRA can still be recharacterized by the due date for the filing of the owner’s Form 1040 income tax return. An annual contribution to a Roth IRA might need to be recharacterized if the owner later discovers that his/her income for the year precluded them from making a Roth IRA contribution.

Reasons to Recharacterize: The reasons why a converted Roth IRA might be recharacterized by the IRA owner include some of the following: (i) the value of the investments held in the converted Roth IRA has decreased since the date of the conversion (meaning income taxes were paid  by the IRA owner on now ‘phantom’ assets); (ii) the Roth IRA owner does not have enough cash to pay the additional income taxes that result from their Roth IRA conversion; or (iii) the Roth IRA owner earned more taxable income than what was anticipated when the Roth conversion occurred in 2017, and the recognition of additional taxable income that results from that conversion pushing the owner’s taxable income into a marginally higher federal income tax bracket. The last might be important in light of the dramatic drop in income tax rates with the 2017 Tax Act, meaning that the IRA owner, using hindsight, would prefer to effect the Roth conversion in 2018 when marginal income tax rates are lower.

Example: Bill, a single taxpayer age 45, converted $60,000 from his traditional IRA to a Roth IRA in 2017. Bill’s earned income for 2017 was $80,000. Thus, Bill was in the 25% federal income tax bracket in 2017. With Bill’s Roth conversion, Bill’s taxable income for 2017 was $140,000 [$80,000 earned + $60,000 due to the Roth conversion.] As a result, Bill was in the 28% federal income tax bracket for 2017, with a federal income tax obligation of $16,800 additional tax due to the amount of the Roth conversion. Assume that the investment performance in Bill’s Roth IRA for the first 2/3rd of 2018 has been miserable [like he invested all the converted funds in emerging markets], and the Roth IRA dropped $40,000 in value. By making a timely recharacterization election to his Roth IRA conversion amount, Bill will remove $60,000 from his 2017 taxable income. This will eliminate the $16,800 income tax on the Roth IRA conversion, and drop Bill back to the 25% marginal income tax bracket (for 2017.). 30 days after the Roth recharacterization, Bill will convert the $40,000 [remember he lost $20,000 in investment value during the first part of 2018] back to a ‘new’ Roth IRA. That amount will be taxed at a 24% tax rate, which then results in an income tax on the $40,000 converted to Bill’s ‘new’ Roth IRA of $9,600 in 2018. Note that this example excludes any amount of income earned by Bill’s Roth IRA prior to its recharacterization, but that income amount must also be recharacterized as well as the converted Roth IRA amount.

Recharacterization Rules:

  • Deadline: To recharacterize a converted Roth IRA back to a traditional IRA the owner has to transfer the converted amount, plus the net income or losses attributable to the transferred assets, by October 15, 2018. As noted, there will be no recharacterizations for future Roth IRA conversions.
  • Roth Contribution Recharacterizations: Recharacterizations will continue for Roth IRA contributions that are found to be disqualified, usually because the taxpayer earned too much in the year of the Roth IRA contribution. A taxpayer must have modified adjusted gross income of no more than $120,000 [$189,000 if married] to be eligible to make a Roth IRA contribution. Example:  a Roth IRA contribution is made and it is later discovered that the owner’s modified gross income for the year was larger than $120,000;  that disqualified Roth IRA contribution can be recharacterized by the owner prior to his/her tax filing date in order to avoid the 6% penalty for that excess contribution. That 6% penalty is imposed on the excess amount held in the Roth IRA each year until that excess contribution is remedied by the owner.
  • Irrevocable: The Roth IRA owner’s decision to recharacterize a converted Roth IRA is irrevocable.
  • Partial Roth Recharacterization: A Roth IRA recharacterization is not an ‘all-or-nothing’ decision. Often a partial Roth IRA recharacterization is used to ‘play the income tax bracket game,’ where the amount not recharacterized is determined to be an amount to keep the IRA owner from moving into the next higher federal income tax bracket; the Roth IRA recharacterization pinpoints the amount needed to be convert to ‘fill-up’ the owner’s marginal income tax bracket but not to exceed it.
  • 30 Day Wait: The recharacterized amount can later be transferred (again) from the owner’s traditional IRA into their ‘new’ Roth IRA 30 days after their initial Roth IRA recharacterization. Thus, if the recharacterization of the owner’s Roth IRA back to a traditional IRA occurred on October 14, 2018, the same amount could be later transferred by the owner to a ‘new’ Roth IRA beginning on November 14, 2018 ( a year when federal income tax rates are lower.)
  • IRS Forms: Unfortunately there are a lot of forms to file to timely pull off a Roth IRA recharacterization. The Roth IRA custodian must be advised of: (i) the type and amount of the contribution to be recharacterized; (ii) the date and year the contribution was made by the IRA owner to the Roth IRA; (iii) a formal request from the owner to complete a custodian-to-custodian transfer of both the amount of the Roth IRA conversion and the net income allocable to that converted amount to be recharacterized; and (iv) the identity of the sponsor of the Roth IRA and the traditional IRA. Recharacterizations are reported on Forms 1099-R [by the Roth IRA custodian] and 5498 [by the traditional IRA custodian.]
  • Amended Form 1040: The Roth IRA owner will have to amend the former year’s Form 1040 income tax return to report their ‘new’ lower taxable income that is subject to tax if the Roth IRA  conversion is recharacterized, including a statement attached to the owner’s Form 1040 that explains the Roth IRA  recharacterization.
  • ‘Net Income Attributable:’ A complex formula is used to determine the amount of income earned by the converted Roth IRA amount, while in the Roth IRA, since that net income attributable to the IRA conversion amount must also be recharacterized back to the owner’s traditional IRA. The IRS uses a ‘last in, first out’ rule with the amount distributed applied from the last contribution to the Roth IRA. It also uses the entire Roth IRA account’s income in this calculation process to determine the amount of income earned by the recharacterized contribution amount held in the Roth IRA. Come custodians will perform this calculation, while others simply follow the Roth IRA owner’s direction as to the amount to be recharacterized. I would be a good idea, whoever calculates the income earned on the converted Roth IRA account, to check their math.

Conclusion: By eliminating Roth IRA recharacterizations, Congress effectively killed the tax bracket-conversion strategy. For those Roth owners who converted their traditional IRA to a Roth IRA in 2017, this will be their last chance to recharacterize their Roth IRA back to a traditional IRA, which may make sense for many Roth IRA owners who made a conversion in 2017, who may now wish to take advantage of the lower income tax rates imposed by the 2017 Tax Act on the conversion amount.