Considering converting assets to your Roth IRA this year? If you are, seek tax advice and carefully consider the tax consequences, as once assets are converted, the transaction can no longer be undone. Congress eliminated the ability to reverse a Roth IRA conversion—known as a recharacterization—as part of the recently passed tax reform bill.
A Roth IRA conversion allows you to convert Traditional IRA assets to a Roth IRA or roll over employer-sponsored retirement plan assets to a Roth IRA. You pay taxes on all pre-tax assets that you convert—but not the 10 percent early distribution penalty tax—regardless of your age at the time of conversion. Once you convert, you have the advantage of tax-free growth in a Roth IRA, and you will avoid required minimum distributions during your lifetime—allowing you to pass along tax-free IRA assets to your heirs.
The advantages of a Roth IRA make Roth IRA conversions very attractive, but individuals often face a challenge when deciding whether to convert, because they are unable to determine the tax impact of the conversion until long after the transaction occurs. Any number of events during the year of conversion, including the sale of securities, purchase of a home, new job, or salary increase can affect your taxable income. A Roth IRA conversion transaction early in the year that looked manageable from a taxation impact may become unaffordable by tax time.
Individuals who underestimate the cost of the conversion often discover at tax time that they do not have the money to pay the taxes on the conversion. Congress recognized this when it created the ability to convert assets to a Roth IRA, and created recharacterization as a way to reverse the transaction and the tax outcome that it creates. In other words, if you are unpleasantly surprised at tax time and want to change your mind, you get a do-over. But now that Congress has eliminated the ability to recharacterize a Roth IRA conversion, once you convert, you have no way to reverse the transaction and are stuck with the tax consequences.
This change in the tax law should not dissuade you from converting assets to a Roth IRA. If you believe that your tax rate in retirement will be higher than your current tax rate, or if you want to avoid required minimum distributions and pass along tax-free IRA assets to your heirs, then converting to a Roth IRA may be advantageous to you. However, before you convert, you should seek tax advice and carefully consider the tax consequences, including any potential changes to your income and your ability to pay the taxes on the conversion. If you cannot pay the taxes and still want to convert, consider spreading out the conversion over a number of years. You can convert a portion of your assets to a Roth IRA each year and pay taxes only on the amount of pre-tax assets you convert each year.
“Converting to a Roth IRA offers substantial tax advantages for many individuals—even after payment of the taxes associated with the conversion—but the elimination of the ability to recharacterize a Roth IRA conversion sets up a tax trap for the unwary,” according to Dennis Zuehlke, Compliance Manager for Ascensus, which provides retirement plan services to financial organizations nationwide. Anyone considering converting assets to a Roth IRA should seek professional tax advice. “Individuals who convert and do not seek tax advice may not be aware of the tax impact until they file their federal tax return months later. If they converted assets and do not have the money to pay the taxes, they are now stuck with their decision, and cannot reverse the transaction or the tax impact associated with it,” Zuehlke added.
Although recharacterization is no longer permitted for Roth IRA conversions, recharacterization is still permitted for annual IRA contributions. Contributions to a Roth IRA can be recharacterized to a Traditional IRA, and contributions to a Traditional IRA can be recharacterized to a Roth IRA under the current recharacterization rules.