Reviewing the Roth Recharacterization

Business_meetingTax time is a good time to review Roth IRA tax strategies with your estate planning attorney. According to a recent Investment News article, "Tax-time Roth IRA strategies," a Roth recharacterization allows a Roth conversion to be undone. A Roth recharacterization takes substantial tax risk out of the Roth conversion decision, and it's one of the rare second chances granted by the tax code. It's an "undo" and erases the Roth IRA conversion like it never happened.

Why recharacterize? The top reason people do this is because the account has declined in value. A recharacterization cancels out the conversion, and the conversion tax is eliminated. At tax time, some folks get a case of buyer's remorse and don't want to pay the tax on the conversion. That's OK.

Since a recharacterization reverses a Roth conversion, the funds must go directly from the Roth IRA to the traditional IRA. You can't withdraw the converted funds from the Roth IRA and then deposit them back into the traditional IRA. You can do either a full or partial recharacterization. If you want to file by this year's April 18, 2016, deadline, you can do so and then recharacterize prior to October 17, 2016. In that case, you would need to file an amended return and get your tax money back with interest.

Backdoor Roth IRA Conversion. This involves two separate transactions: a contribution to a nondeductible IRA and a Roth conversion. It's known as a "backdoor" Roth conversion because it results in having the contributed funds end up in a Roth IRA, even if income was too high to make a Roth IRA contribution. That said, you should be aware of the following:

  • The individual must have earned income, such as wages or self-employment income;
  • You can't be over age 70½, as traditional IRA contributions can no longer be made for the 70½ year and later years;
  • The pro-rata rule will apply, and all of your traditional IRAs are included in the pro-rata calculation, meaning that some of the back-door Roth conversion will be taxable if there are other pre-tax funds in any IRAs;
  • Funds that end up in the Roth IRA via a backdoor conversion are converted funds, rather than Roth IRA contributions. This is a big deal for those under age 59½—those funds must be held for five years to avoid a penalty, but if the funds went in as a Roth IRA contribution, they could be accessed immediately, both tax- and penalty-free.

Speak with an experienced estate planning attorney to make sure that this is the right strategy for your situation.

Reference: Investment News (February 19, 2016) "Tax-time Roth IRA strategies"

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