Retirement Perspectives
October 16 Is the Deadline for Reversing Roth Conversions
Investors who convert to Roth IRAs still have time to change their minds and reverse or unwind the conversion through a process known as recharacterization.
Recognizing that mistakes sometimes happen, the tax code allows IRA accountholders to change their minds via a “do over” technique called recharacterization.
Recharacterization allows an individual to unwind or reverse a Roth IRA conversion. A Roth conversion triggers federal income and (if applicable) state income tax liability, whereas a recharacterization eliminates the tax liability altogether.
Anyone can bring about a recharacterization for any reason. However, there is a deadline rapidly approaching—Monday, October 16, 2017—that allows the recharacterizing of 2016 conversions and IRA contributions. So, now is the time to contact clients who converted assets to a Roth IRA, in case they’re having second thoughts.
The October 16th deadline applies to recharacterizing a conversion done in calendar year 2016. This deadline applies even if taxes were filed in a timely manner—in other words, an individual can report a recharacterization via an amended 2016 tax return. An individual may be eligible for a refund if taxes were previously paid.
The custodian will transfer the funds along with any earnings/losses directly from the first IRA to a second IRA. Although this is a tax-free transaction, the transaction is reported to the IRS. In addition, the investor will receive a 2017 Form 1099-R from the first IRA and a 2017 Form 5498 (box 4) from the second IRA.
Here are 11 tips for a seamless recharacterization:
1. Check with the IRA custodian(s) regarding the paperwork and process required to recharacterize.
2. Recharacterization is required to be processed via a “trustee-to-trustee” transfer.
3. October 16 is a hard deadline. In other words, the recharacterization process must be finalized by that date. We suggest contacting your IRA custodian regarding the timing of the recharacterization. Waiting until October 16 could prove problematic.
4. A full or partial recharacterization is permitted.
5. An individual is allowed to reconvert after recharacterizing. But certain timing must be followed: an individual must wait until the calendar year following the original conversion or more than 30 days, whichever is longer.
6. There may be an advantage to establishing a separate Roth IRA (conversion) for each individual investment. A Roth IRA contribution that is ineligible because a taxpayer’s income exceeded the Roth IRA income limit can be recharacterized to a traditional IRA contribution. The rules for this recharacterization generally follow most of the excess IRA contribution rules.
7. Whatever amount is recharacterized does not have to go back to the same IRA from which it originally came. Any traditional IRA is permitted.
8. A Roth conversion that was initiated from a qualified plan, such as a 401(k), cannot be recharacterized back to the plan. Instead, the funds would need to be transferred to a traditional IRA.
9. A conversion of a pretax 401(k) funds to a Roth 401(k) (not IRA) is not eligible for recharacterization; the transaction also is irrevocable.
10. As long as a maze of rules and deadlines are adhered to, an account owner can play the conversion/recharacterization/reconversion game indefinitely.
11. Regulations permit post–death recharacterization by the executor of the accountholder’s estate.
Worried about extra paperwork? Partner with your CPA or tax professional, because reporting a rechacterization can involve multiple tax forms.
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The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.
