Recharacterization of Roth Conversions: Exit Stage Left in 2018

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA), the most comprehensive piece of tax reform since the Bush era tax cuts circa 2001-2003. Among the most significant changes affecting individual taxpayers were a lowering of the marginal tax brackets, an almost doubling of the standard deduction, suspension of personal exemptions, and an increase in the child tax credit along with more generous income thresholds to be able to take advantage of the credit.

As a retirement planning practitioner, I was concerned that, after years of being on the proverbial chopping block, the inherited IRA rules allowing non-spousal beneficiaries to stretch distributions over a period based upon their life expectancy would be eliminated and give way to only a 5-year period. Surprisingly, the inherited IRA was left alone and, at least for now, remains intact.

However, much to my chagrin, the Roth conversion was not left completely unscathed under the TCJA. Conversions to a Roth IRA from either an employer-sponsored plan or a traditional IRA have been used over the years as a powerful tax diversification tool. While the converted amount is subject to ordinary income tax upon conversion, in theory, now you have taken a pre-tax retirement vehicle and made at least a portion of it eligible for tax free distributions later by converting to a Roth IRA. Not only is a qualifying Roth IRA distribution tax free, balances in Roth IRAs are not subject to lifetime RMDs AND distributions to beneficiaries upon death may be distributed, in most cases, tax free over many years.

Roth conversions themselves are still alive and well. But under TCJA, the ability to rechactacterize a Roth conversion by October 15th of the year following the conversion was permanently repealed in 2018 and beyond. Recharacterization allows an individual to take more risk per se because the ability to change his/her mind later and send the converted amount plus earnings back to its original home meant that if there was a significant market loss on the converted amount or the individual’s tax situation changed, the conversion could be undone thereby eliminating the taxes due on the conversion.

The fact that recharacterization is no longer permitted doesn’t mean that the Roth conversion isn’t still a powerful tax diversification strategy. It just means that more time and consideration should be given to the potential outcome if circumstances change post-conversion. It may make more sense to wait until closer to year end when one’s tax picture is more clearly defined and less likely to change substantially. Smaller conversions over several years to mitigate the risk of a large tax bill all at once is always an option as well.

A couple of things worthy of mention are these. First, IRS has verbally indicated on more than one occasion that conversions that occurred in 2017 are still eligible to elect to recharacterize by October 15, 2018. So, if you have clients who converted in 2017, it’s a good idea to reach out and make sure that they are comfortable with the decision to convert and have the means to pay the taxes due on the conversion. This is their last chance to get a do-over.

Second, the repeal of recharacterization only extends to Roth conversions and not to amounts contributed to either a traditional IRA or Roth IRA. For example, let’s say I contribute $5500 to my traditional IRA for 2017 only to discover that I was ineligible to deduct it but still meet the income thresholds to contribute the same $5500 to a Roth IRA. I elect to recharacterize my contribution originally made to my traditional IRA to a Roth IRA. The only stipulation is that I also must recharacterize any earnings on the contributed amount with it. My deadline to do this is my tax filing deadline, plus extensions.

Make no mistake. The Roth conversion can still be a powerful tool to add to an overall retirement income planning strategy or as part of a legacy plan. Clients just need to proceed with greater caution in 2018 and beyond.

HLS Retirement Consulting, LLC is an independent consulting firm and is not affiliated with any other company and does not endorse or recommend investment products. Consulting provided herein should not be construed as tax or legal advice. Your clients should always seek guidance from their tax or legal counsel prior to following a proposed course of action.