Disclaimer: Please note that the Tax Cuts and Jobs Act of 2017 removed the ability for taxpayers to do any “recharacterizations” of Roth IRA conversions after 12/31/2017. The material below was created and published prior the passage of the Tax Cuts and Jobs Act of 2017.
Rebecca Katz: We just got this great question in that I was going to ask you myself if nobody else did. This is from George in North Carolina, so thank you, George. “Please explain Roth re-characterization.” Is this the “oopsie, I converted and I shouldn’t have done that”?
Maria Bruno: Yes, but it’s not always an oopsie. It could be a very viable strategy that someone is employing. Actually we’re having these conversations right now because at the end of last year there was a lot of uncertainty around what would happen with 2013 tax rates. So some investors actually decided they would convert, and then maybe decide to re-characterize later. So what a re-characterization is is it’s really almost a mulligan; the IRS lets us do a do-over. So if you convert to a Roth IRA or even if you contribute to a Roth IRA and then decide that you want to reverse that, the IRS allows you to do that.
Now there are some stipulations; there’s holding period requirements. So if you converted last year, for instance, and you want to re-characterize this year, you have until essentially October 15 to do that. So it’s a tax filing deadline or a tax extension.
So you can convert them. Basically what it does is it takes whatever—whether it’s a partial re-characterization or a full re-characterization—brings that back into a traditional IRA. So any earnings or losses would be carried back over into that traditional IRA. The end result is as if the conversion never happened or the Roth contribution never happened.
Joel Dickson: Where this can be valuable is, for example, although this is not as likely this year—given that we’ve had pretty robust financial market returns—but let’s take that $100,000 that we had been talking about earlier and you converted that from a traditional to a Roth IRA. Let’s assume that it was fully taxable, so it was all $100,000 of pre-tax dollars.
If the investment that you put it into in the Roth IRA were to have gone from $100,000 to $80,000, that is, declined 20%, sort of go “Well, why should I pay taxes on $100,000 when right now the account is worth $80,000?” So re-characterizing back to the traditional IRA where now you have $80,000—and then once you get over the certain requirements to then do a reconversion, which basically is either 30 days following the re-characterization or the next tax year—it sort of depends on where you are in the tax cycle. You would now just reconvert $80,000 and pay tax on $80,000, instead of paying tax on $100,000 if you wouldn’t have re-characterized.
Rebecca Katz: Assuming the markets didn’t go back up.
Maria Bruno: There’s holding periods. So you’re kind of at the mercy of the markets, almost, depending on how you’re invested. You can actually put the monies back into the traditional IRA and keep it there or you can actually reconvert after the holding period expires.
Joel Dickson: One of the things that I do think we have to be careful about in 2013—because as Maria mentioned there was a lot of uncertainty about tax rates, we have the fiscal cliff, all that kind of stuff—for some people tax rates increased in 2013 from where they were in 2012, either through all of the deductions changing, or through the Medicare, or through ordinary income tax rates. So even if the account went down in terms of the value of the conversion from a traditional to a Roth, it might not make sense to re-characterize, because now you would be reconverting in 2013 or 2014 at potentially higher tax rates. So what matters is the total tax bill, not so much the amount in the account.
All investing is subject to risk, including the possible loss of the money you invest.
Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
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