The new tax reform law, the Tax Cuts and Jobs Act (TCJA), includes a crackdown on recharacterizing a Roth IRA. Beginning in 2018, retirement-savers can longer undo a Roth conversion due to a decline in value or some other reason. But there’s still a small window of opportunity left open for such rechacterizations.
According to a new series of Frequently Asked Questions (FAQ) posted online by the IRS, you can recharacterize a Roth conversion made in 2017, as you meet the tax return deadline, plus extensions. Of course, FAQ postings can’t be cited as official tax authority, but it’s a strong indication of the way the IRS is leaning.
A Roth IRA offers the lure of tax-free payouts in the future. As opposed to distributions from a traditional IRA, which are taxable to the extent they represent deductible contributions and earnings, “qualified distributions” from a Roth at least five years old are completely exempt from tax. For this purpose, qualified distributions are those made after age 59½, on account of death or disability or used for first-time homebuyer expenses (up to a lifetime limit of $10,000). Furthermore, other distributions may be wholly or partially tax-free under "ordering rules" treating non-taxable amounts as coming out first.
But there’s a stiff tax price to pay for this privilege: The conversion is currently taxable based on the value of the transferred funds on the date of the conversion. If the value of the assets dropped after the conversion or you otherwise had a change of heart, you previously could recharacterize the Roth back into a traditional IRA. It was as if the conversion had never occurred.
Under prior law, the deadline for recharacterizing a Roth was the tax return due date for the year of the conversion, plus any extensions,
Of course, the stock market has been booming lately, but suppose the bottom drops out later this year. If you converted to a Roth in 2017, you may have to pay a high tax on over-priced assets.
For example, say you’re in the 39.6% tax bracket for 2017. If you converted $1 million to a Roth in 2017, you’d owe $396,000 on the conversion. But now suppose the value of the account plummets to $700,000. In effect, you are overpaying the tax by a staggering $118,800 (39.6% x $300,000 drop in value)!
According to the IRS FAQs, you have until October 15, 2018 to recharacterize a 2017 Roth conversion without any consequences. But the IRS reiterates that a Roth conversion made after December 31, 2017 can’t be recharacterized. The FAQs can be found at https://www.irs.gov/retirement-plans/ira-faqs-recharacterization-of-ira-contributions.
Get the word out to your clients about the latest development. They can keep this tax break in their hip pocket, to be used only if needed.