Did you convert your Traditional IRA to a Roth IRA? Do you worry you may have done it too soon if Tax Reform Passes?
A lot of people are asking the question, “What if tax reform passes? What will happen since I When you convert a traditional IRA to a Roth IRA, you have to pay the tax on the conversion. However, individuals frequently do that so they can take advantage of future tax-free accumulations. Distributions from Roth IRAs are generally tax free, including any earnings (accumulations) while the account is a Roth account.
Are you considering converting your traditional IRA to a Roth IRA in 2017?
So what if tax reform passes? Are you hesitant to do so because of uncertainty about the timing and specifics of the Trump Administration’s and Congress’ proposal to cut tax rates for individuals? Have no fear! You can convert your traditional IRA to a Roth IRA this year. And, what if tax reform passes with lower tax rates effective next year? You can undo the conversion for 2017 and re-convert for 2018.
Tax Law Allows Individiduals to Undo an IRA Transfer and Reconvert
Sounds like religion doesn’t it? But it is not. It is common tax practice. Tax law allows individuals who convert in one year to undo that conversion by a procedure known as recharacterization. The procedure has been in use for years, primarily by individuals whose invest IRA funds into stocks. An individual converts from their traditional IRA funds to a Roth IRA only to see the value of their Roth IRA decline after the conversion. This is usually due to stock market fluctuations. Recharacterizations are also used by individuals who convert their traditional IRA to a Roth IRA and then found they could not or did not want to pay the conversion tax.
IRA Conversion Scenario
Anyone can use this same process for any purpose. So, for example, if you converted your regular IRA to a Roth IRA in 2017 and Congress enacts tax reform effective in 2018. The outcome is that you can recharacterize or undo your 2017 conversion back to a traditional IRA. However, the recharacterization must be complete by the extension due date of your 2017 tax return. For 2018 that is October 15th. If you choose to, you then can then reconvert the traditional IRA to a Roth IRA in 2018 and take advantage of the new lower tax rates.
What If Tax Reform Passes? What is the wait period to undo an IRA?
Generally, you must wait at least 30 days to make the reconversion. However, if you make the recharacterization of the Roth IRA back to your a traditional IRA in 2017, you may not reconvert that amount from the traditional IRA to a Roth IRA before the beginning of 2018. Or else, if it is later, the end of the 30-day period beginning on the day on which you transferred the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.
An IRA Conversion and Tax Implication Example
Example: For years, Jack has been making deductible traditional IRA contributions. Then, during the summer of 2017, Jack decided to convert $25,000 of those traditional IRA funds into a Roth IRA. After the conversion is doen, late in 2017, Congress passes and the President signs a tax reform bill. The tax reform fill reduces Jack’s marginal tax rate in 2018. To take advantage of the lower tax rate, Jack recharacterizes (undoes) the conversion back to a traditional IRA for 2017. He then reconverts the funds back to a Roth IRA in 2018. To do that, Jack first transfers the $25,000 (plus earnings or minus losses since the original conversion) back to a traditional IRA by way of a trustee-to-trustee transfer (it’s OK for the transfer to be with the same financial institution). He could make the recharacterization as late as October 15, 2018, but chooses to do so on January 15, 2018. Then, after making the transfer back to the traditional IRA, Jack reconverts the amount back to a Roth IRA on Feb. 20, 2018.
Questions About Conversions and Recharacterizations After Tax Reform?
Phew, that’s quite the example isn’t it? So that is basically what happens when you ask, “What if Tax Reform passes? For more information on recharacterizations and conversions, and how they might fit into your tax planning, please give Alex Franch, BS EA a call at 781.849.7200 or email us at email@example.com.
Tax Reform and IRA Conversion Sources and Resources