Question Of The Week: What is a Roth Recharacterization?

When my 3 boys where younger, there always seemed to be a verbal skirmish or two going on in. I know what you’re thinking. With 3 boys - lots of fights; all kinds of physical stuff.

Roughhousing and the like…Not so much in my house. Their fights were more intellectual, like the time my two older sons were fighting over an imaginary piece of paper. (I’m still trying to figure that one out.)

Anyway, whenever an argument would break out, each of the effected parties would characterize the events differently. As I look back, it seems that they were recharacterizing what happened, so they could have the pleasure of seeing their punished!

That’s what I think about when I hear the term recharacterization. What comes to mind for you? Could it be completed a Roth conversion and, over time for one reason or another wanting to take it back?

Well, the good news is a recharacterization is a common practice and, for those of you with money in in traditional IRA accounts, it’s actually a wonderful tool to help you save tax dollars. Let’s dig deeper on this topic.

Before we can have a recharacterization, we must first do a Roth conversion.

This occurs when you convert funds from a traditional IRA to a Roth account. It’s not only a way of avoiding tax rate risk in the future, but also a method that allows converted funds to grow tax free for the rest of your life.

As you know, though, this tax-free benefit does NOT come without a price. When you convert, you are removing money from the tax-deferred bucket. This means the tax will be deferred no longer and the election requires that you pay some income tax. You’ll know this because you’ll receive one of those pesky 1099 forms at the end of the year. This is how you know tax is due. The great news is that anybody can do a Roth conversion and it’s a strategy I highly recommend for most people.

Now comes the fun part. Some people after converting - and much like my wife probably did after we exchanged vows - have second thoughts.

Could be any of the following reasons:

  • The value of your investments in the converted Roth IRA have declined.

  • Your taxable income has ended up being higher than you expected and/or the additional income from the Roth IRA conversion has bumped you into a higher federal income tax bracket.

  • You've determined that your taxable income in retirement will likely be lower than you expected, reducing the potential benefits of a Roth IRA’s tax-free distributions. (Author note: This is one of those myths. I find that this is rarely the case. Most people end up in the same or a higher bracket in retirement.)

  • You don't have enough cash on hand to pay the taxes.

The first bullet point above is quite common so let’s examine that further. Let’s say you convert $50,000 and your marginal tax rate is 25%. You would pay $12,500 in tax. (I know it’s a bitter pill to swallow; however, you were going to pay the tax at some point anyway.) Let’s assume that you’re invested in a stock fund that’s doing well at the time you make the election. Let’s further assume that shortly thereafter the market drops 20% and your stock fund takes a similar hit. Now your $50,000 is only worth $40,000 and you have technically paid an extra $2,500 in tax. (If this is confusing, think about it this way. If you had converted when the values were lower [$40,000] you would have paid less tax. This can be understandably be quite upsetting!)

Not to worry, though the IRS allows some relief when this occurs. From IRS.GOV.

A recharacterization allows you to “undo” or “reverse” a rollover or conversion to a Roth IRA. You generally tell the trustee of the financial institution holding your Roth IRA to transfer the amount to a traditional IRA (in a trustee-to-trustee or within the same trustee). If you do this by the due date for your tax return (including extensions), you can treat the contribution as made to the traditional IRA for that year (effectively ignoring the Roth IRA contribution).

You generally can recharacterize your rollover or conversion by October 15 of the following year, regardless of whether you requested an extension to file your tax return. For example, for your conversion to a Roth IRA in 2016, you have until this October 15th (2017) to recharacterize.

Many people like to have some fun with this. Try to game things, if you will and they ask - when can you recharacterize again?

If you recharacterize all or part of a rollover or conversion to a Roth IRA, you cannot reconvert the amount recharacterized to the same or another Roth IRA until the later of:

  • 30 days after the recharacterization, or

  • the year following the year of the rollover or conversion.

There is a way around this. The waiting period to convert applies only to amounts you recharacterized. For example, you can convert amounts from a different traditional IRA to a Roth IRA immediately. For those of you with multiple IRA accounts, you are free to convert from a different account when you feel the timing is right. More from Fidelity.

You can manage the tax cost of your conversion by using recharacterization strategically. Instead of just one conversion or multiple conversions into one Roth IRA account, you can make separate conversions into separate Roth IRA accounts. You might do this by asset type or even by individual investments. Then you could later choose to recharacterize only those Roth IRAs that have declined in value. Current rules allow you to recharacterize by account. If you convert into a single account, you will effectively have to recharacterize a pro rata portion of the gains on all your other investments, as well as the losses. In fact, if your portfolio overall gains, you will likely not recharacterize at all, and so potentially miss the opportunity to save on the tax cost of conversion.

Sounds like great fun! Whatever you do keep good records on what you’re doing. It’s easy to get tripped up and you don’t need any hassles if the IRS comes calling.

That’s just the way it works!

Required disclosures: Investment advisory services offered through Brookstone Capital Management, LLC (BCM), a registered investment advisor. BCM and (Strataxa Retirement Advisors, LLC) are independent of each other. Insurance products and services are not offered through BCM but are offered and sold through individually licensed and appointed agents.

Information provided is not intended as tax or legal advice, and should not be relied on as such. You are encouraged to seek tax or legal advice from an independent professional