- The tax reform bill that passed in December 2017 eliminated the ability to recharacterize Roth conversions for taxable years after 2017.
- If you converted to a Roth IRA in 2017 and feel it would be advantageous to reverse the conversion, you may be able to complete a recharacterization by the October 2018 deadline. You should consult a tax professional about your particular situation.
There are good reasons to convert a traditional IRA to a Roth IRA through the ability to take tax-free withdrawals in retirement can have many many advantages.1
However, there also may be reasons to reverse a Roth IRA conversion. For instance, a process known as recharacterization. But the window for recharacterizations is closing quickly, as the tax reform bill eliminated this strategy beginning in the 2018 tax year. If you converted to a Roth in 2017, you may be able to complete a recharacterization by the 2018 deadline.
Why would you consider recharacterizing a conversion completed in 2017? There are several reasons. For instance:
- The value of investments in the converted Roth IRA has declined since the date of the conversion.
- Higher than expected taxable income and/or the additional income from the Roth IRA conversion resulted in a bump to a higher federal income tax bracket.
- Taxable income in retirement will likely be lower than expected, reducing the potential benefits of a Roth IRA’s tax-free distributions.
- Not enough cash on hand to pay the taxes resulting from the conversion.
The process of reversing a Roth IRA needs to be completed by the last date, including extensions, for filing or refiling a prior-year tax return, which is typically on or about October 15. All or a portion of what was converted can generally be recharacterized. And assets that are recharacterized to a traditional IRA can be reconverted to a Roth IRA in the next tax year after the conversion or 30 days after the recharacterization, whichever is later.
Richard, looking to take advantage of the potential benefits of a Roth IRA in retirement, converted $50,000 from his traditional IRA to a Roth IRA on March 1, 2017. He planned to pay $12,500 from his taxable brokerage account to cover federal income tax on the conversion (he’s in the 25% bracket) when he files his 2017 taxes.
Richard filed and paid the tax before the usual deadline of April 15, 2018, but the value of the investments in his Roth IRA was down to $30,000 by the end of July of that year. Because his tax liability would have been less if he had converted then, Richard decided to recharacterize his conversion to a traditional IRA on August 1, before the October deadline. He processed the transaction with his broker and filed an amended tax return to exclude the initial $50,000 conversion from his reported income for prior year.
When he was eligible, on September 1, and with the help of his broker, he reconverted his traditional IRA, which in the interim had increased in value to $35,000, to a Roth IRA. This reconverted value will be included in his tax return, with an estimated tax of $8,750. Even though the account value has risen somewhat from the low point of $30,000, the recharacterization may still save him $3,750, or 30% of the tax cost of his initial conversion.
Using recharacterization as a strategy
The tax cost of a conversion can be managed by using recharacterization strategically. Instead of just one conversion or multiple conversions into one Roth IRA account, separate conversions into separate Roth IRA accounts can be done—either by asset type or even by individual investments. Then only those Roth IRAs that have declined in value would be recharacterized. Current rules (i.e., the rules that apply to conversions made in 2017) allow recharacterizion by account. A single account conversion means effectively recharacterizing a pro rata portion of the gains on all other investments, as well as the losses. In fact, if an overall portfolio gains, a recharacterization may not make sense at all, and be a potentially missed opportunity to save on the tax cost of conversion on the parts of the portfolio that did decline.
Once the October 15, 2018 recharacterization deadline has passed, consolidating Roth IRAs into a single account again to make them easier to manage may be something to consider.
Consider this hypothetical example. Caroline, age 55, has $100,000 in a traditional IRA, of which $50,000 is invested in U.S. stocks, $10,000 in international stocks, and $40,000 in bonds and bond funds. By making several separate conversions into separate Roth IRA accounts, she can help manage her tax liability on the conversions. The chart below shows how this could work.
Converting by asset class enables Caroline to keep the Roth IRA accounts that have increased in value and recharacterize those that haven’t, which could potentially save her $3,500 on the tax cost if she converts the stocks to a Roth again at the lower stock prices. She may even want to separate conversions further by individual investments.
This is a sophisticated strategy, and should be discussed with a tax adviser to implement it correctly. It is also important to ensure that dividing a conversion into multiple accounts doesn’t needlessly incur additional fees, such as minimum balance fees or additional tax preparation costs.The cost, in terms of time and effort, of keeping track of the paperwork for the multiple conversions and accounts should also be considered.
Think before acting
Recharacterization may be a chance to reduce the tax liability on a Roth IRA conversion. The rules can be confusing, so make sure to check with a tax adviser to understand the potential impact on your tax situation. With the tax law changing in 2018, it's vital to be sure of your decisions.
Next steps to consider
Create an appropriate investment strategy for your IRA.
How to report recharacterization transactions to the IRS.
Factors to consider before converting assets to a Roth IRA.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.