Traditional IRA vs. Roth IRA–Time to Reconsider that Roth Conversion?

IRA RothOne of the most basic decisions a taxpayer must make when thinking about retirement vehicles revolves around the difference between traditional investments and Roth investments.  When Roth IRAs first surfaced in 1997, the promise of tax-free distributions made them extremely popular.  Many taxpayers even took advantage of the opportunity to convert their traditional IRAs to Roth IRAs to take advantage of Roth features.  However, some taxpayers have realized that the disadvantages of the Roth might outweigh the benefits in certain circumstances.  For those taxpayers, hope may be found in a recharacterization.

A recharacterization is the process that allows a taxpayer to undo or reverse a Roth IRA conversion and revert back to a traditional IRA.  A recharacterization may make sense when taxpayers:

  • Incur unexpected expenses and want to unwind a prior conversion in order to get back cash they paid in taxes at the time the Roth was initially funded.
  • See a dramatic decrease in their investment after a conversion and want to avoid paying tax on a higher value than they actually have.
  • Anticipate having unusually high deductions or a lower income than normal and want to use a portion of the conversion as a post-year-end planning opportunity.
  • Realize that lower expected earnings during retirement might lead to lower marginal tax rates.

A recharacterization is accomplished through a trustee-to-trustee transfer of the funds from the Roth IRA back to the traditional IRA.  The transfer back to the traditional IRA is treated as the original receipt of funds and allows the taxpayer to avoid any tax consequences that would have occurred due to the initial conversion to the Roth IRA. The taxpayer is welcome to execute a recharacterization by the due date of his or her return (including extensions) the year following the initial conversion to the Roth IRA [IRC Sec. 408A (d)(6) and (7)].  If the taxpayer has a change of heart, and decides to reconvert the funds into the Roth IRA, he or she may do so in the tax year following the conversion or 30 days after the recharacterization, whichever is later.

A taxpayer can expect to receive several information returns when a conversion is recharacterized including Form 1099-R for the recharacterization and Form 5498 for the gross amount received in a recharacterization (contributions plus earnings).

Overall, recharacterization is a good strategy for taxpayers to potentially reduce their tax liability on Roth IRA conversions, but it is important to know the rules and how they apply to your specific tax situation.  If you wish to discuss your retirement strategy with one of our tax professionals, contact one of our executives below, (800) 270-9629.


Heather Martin

Heather Martin

Senior Manager

Megan Brummitte

Megan Brummitte

Manager

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