Under current law, retirement savers can recharacterize, meaning reverse or undo, a conversion to a Roth IRA from a traditional IRA (or from a 401(k) or 403(b) plan). This allows investors to unwind the conversion and the associated tax consequences. Retirement savers have until December 31 of each year to effect a conversion for that year. They then generally have until October 15 of the year following the conversion (which is the extended due date for the tax return for the year of the conversion) to undo the transaction.
For example, Ms. Bruno said, an investor might want to undo a $50,000 conversion to a Roth IRA if the market subsequently fell dramatically and the account value dropped to $40,000. In this instance, the investor would still pay taxes based on the $50,000 account value at the time of the conversion.
Before the change made in the new tax law, investors could undo the transaction and avoid this higher tax liability. But the new law includes a repeal of the rule that allows for those transactions.
The change could potentially complicate things for some investors.
“Under these circumstances, you suddenly have all this additional income and maybe the Roth conversion is pushing you into a higher tax bracket, and you will now no longer be able to undo it,” Ms. Bruno said.
Importantly, the final version does not change current law for recharacterizations of contributions to a Roth or traditional IRA; these will continue to be permitted. This is a departure from what was included in the original bills passed by the House and Senate, which had eliminated this option along with conversions. For example, an individual may continue to make a contribution for a year to a Roth IRA and, before the extended due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA. An individual may also make a contribution to a traditional IRA and convert that traditional IRA to a Roth IRA for a year but could not then unwind the conversion through a recharacterization.
According to Ms. Bruno, “Some questions have been raised in the industry about whether the legislation would impact an investor’s ability under current law to recharacterize a conversion made in 2017 through October 15, 2018, and instead require a recharacterization before the end of this year. We understand that the legislation has not changed the October 15, 2018, deadline, although the IRS has yet to release formal guidance confirming this.”
Absent formal guidance from the IRS providing otherwise, Vanguard will continue to permit investors to recharacterize their 2017 conversions through October 15, 2018. Vanguard suggests that investors who are considering a recharacterization of a 2017 conversion consult a qualified tax advisor for advice on this issue.
We recommend that you consult a tax or financial advisor about your individual situation.
All investing is subject to risk, including the possible loss of principal.
The information contained herein does not constitute tax advice, and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code.