How the conversion and recharacterization worked
Prior to the TCJA, here is how an individual might have benefited from the Roth recharacterization rules. If an individual has a traditional IRA investment, the individual does not have to pay income tax on the earnings in that account until the funds are withdrawn. When the funds are taken out of the IRA, the individual must pay income tax on the entire amount taken out of the IRA. A Roth IRA is different, though. Contributions to Roth IRAs are not deductible and earnings and distributions taken from the account are tax free. If an individual is in a lower income tax bracket for a certain year than what they would expect to be in when they start drawing on a traditional IRA, they might consider converting that traditional IRA to a Roth IRA. When the traditional IRA is converted to a Roth IRA, the amount that is converted is considered taxable income. If the individual is in a lower tax bracket than when they anticipate drawing on the funds for retirement, they could end up paying less in income tax on that distribution. Any future earnings and distributions taken from the new Roth IRA would then become tax free.
The recharacterization from a Roth IRA back to a traditional IRA comes in handy when the value of the converted IRA drops significantly in the months following the conversion. For example, an individual converts a traditional IRA worth $100,000 to a Roth IRA in December 2017. The individual puts his 2017 tax return on extension, which means he has until October 15, 2018 to file his return and to make any recharacterizations back to a traditional IRA. In October 2018, the value of that $100,000 that was converted to the Roth IRA has dropped to $85,000. The individual would owe income tax on the $100,000 because that was the value on the date of the conversion, rather than the current value of $85,000. Under the old tax law, the individual could recharacterize the Roth IRA back to a traditional IRA, as if the conversion from a traditional to a Roth never happened. He would not owe any tax on the conversion on his 2017 income tax return. He could then convert the $85,000 (or whatever the balance is in December 2018) from a traditional IRA to a Roth IRA again and wait another 9 months to see if the investment increases or decreases.
Strategies with the new law
Converting a traditional IRA to a Roth IRA still may be worth considering going forward but it will take careful thought before doing so. Consider, for example, that your money is in a traditional IRA and in 2018, you’d like to transfer it to a Roth. This means you will need to pay the taxes in the current year. You may be in a lower tax bracket due to the TCJA or maybe even due to a change in your business. Converting now may work in your favor considering you may be in a higher tax bracket in future years as your business grows. However, in the example used above, if you expect the market to take a downturn, you may want to hold off.
Another point to consider is whether you have funds available to pay the taxes that will be owed in a conversion. In this case, a partial conversion each year might be the best bet for the taxpayer that isn’t prepared to pay all of the taxes due at once. And finally, let’s say you’ve been letting your traditional IRA grow over your working life, and now it’s time to retire. You may be at your highest tax rate as you get set to retire, so conversion may make more sense in a future year when your income isn’t as high and your tax rate may be lower.
An important item to note is that the old rules still apply for IRA contributions you make during the current year. For example, if you make a contribution to a traditional IRA during 2018, then decide you would’ve preferred to make it to a Roth instead, you are able, and still will be able, to convert it to a Roth. Then, before you file your tax return, you can take a second look and unwind this transaction if it no longer seems advantageous.
It’s always good to do the math before making a change. A good look at all of your financial pieces to the puzzle can help you make the best decision when it comes to your retirement.