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Retirement Perspectives

Investors who convert to Roth IRAs can change their minds and reverse the transaction through a technique known as "recharacterization." 

Life doesn’t offer many opportunities for "do-overs." Usually, we have to live with the consequences of our decisions, even though we might have made different ones in hindsight.

So it may be a surprise to some investors who converted a traditional, SEP, or SIMPLE IRA to a Roth IRA—and later wish they hadn’t—to learn that the federal government provides what amounts to a “do-over” provision that allows investors to change their minds.  By taking advantage of a technique called recharacterization, investors have a rare opportunity to undo a financial transaction if it doesn’t unfold to their advantage.

The potentially redemptive rule takes some of the risk out of undertaking a conversion in the first place. Since 2010, all Americans who have a traditional IRA (or SEP or SIMPLE IRA) are able to convert all or part of their IRA to a Roth IRA. This represents a unique opportunity, particularly for those whose adjusted gross income (AGI) exceeds $100,000. Prior to 2010, whether married or single, individuals whose AGI exceeded $100,000 were not eligible to convert.

Once a Roth account has been established for at least five years and the owner is at least 59½ years old, all proceeds paid from the Roth IRA are free of income taxes. In addition, neither the account owner nor the surviving spouse (primary beneficiary) is required to take minimum distributions at age 70½. If someone other than a spouse inherits your account, generally tax-free distributions are required.

What’s the catch? Your IRA is subject to income tax in the year in which the conversion takes place. Generally, you are taxed on the converted amount that was not previously taxed, including deductible contributions, earnings, and any pretax dollars that were rolled over from a prior employer’s retirement plan. If you are one of the many Americans who are considering converting to a Roth IRA, you may want to do it as early in the year as possible.

To illustrate why, let’s consider a hypothetical situation: Chris chose to convert a $100,000 traditional IRA to a Roth IRA on January 5, 2015. The account appreciates, and by the end of the year, it is worth $130,000. The value would be the same whether he had converted or not; but had he waited to convert, there would have been, theoretically, an additional $30,000 on which to pay taxes.

But, as we are fully aware, investments do not always appreciate in value. What if Chris had completed the hypothetical conversion as described above, but the investment plunged 30% instead of growing 30%? The value falls to $70,000. Chris has lost money “on paper,” but he still owes taxes on the original $100,000 that he converted. All is not lost, however. As long as it is within the IRS’s prescribed time frame, Chris can choose to recharacterize the Roth conversion back to a traditional IRA, thereby erasing the transaction and any tax liabilities that might otherwise have occurred. The transaction never happened, as far as the IRS is concerned.

Chris has until October 15, 2016, to recharacterize. Therefore, Chris has from January 5, 2015, until October 15, 2016, to evaluate investment performance and decide whether to do nothing or to undo the conversion. October 15 represents the final tax-filing deadline, including extensions. Taxpayers can file an amended tax form any time between April 15 and October 15 of the same year, and they will be refunded any overpaid taxes.  

Retirement Perspectives
Chris owes no taxes on the $100,000 conversion, and the IRA is restored to the type of account (traditional IRA) it was prior to conversion. The account balance, alas, remains the same, at $70,000. But that presents an opportunity of a different kind.

Chris now can reconvert (convert again) the remaining $70,000 to a Roth IRA and pay taxes on its lower value at the time of that conversion. According to IRS rules, Chris must wait either more than 30 days from the recharacterization date or until the next calendar year, whichever is later, before he can reconvert.

The rules of converting differ when it comes to in-plan Roth rollovers, which were permanently expanded under the American Taxpayer Relief Act of 2012. Consequently, employees with eligible retirement plans (401(k), 403(b), or governmental 457(b)) plans can, if the plan allows, convert all vested pretax assets to designated Roth accounts, generally at any time. As with traditional IRA conversions, in-plan conversions are subject to taxation in the year in which the conversion takes place. But unlike with traditional conversions, in-plan Roth conversions are irrevocable. Recharacterization is not permitted. So investors should carefully consider the possibilities before committing to an in-plan conversion.

Advisors should discuss with their clients the various options and potential consequences to determine whether a Roth conversion is right for them. Individuals don’t have to convert the whole amount in 2015. Some taxpayers may feel the tax liability on the full value of their assets is too much. They can convert their account in pieces, or not at all. (See, "Should I Convert to a Roth IRA?" on our Retirement Calculators page in the Retirement section of lordabbett.com.) 

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter. 

The examples in this commentary are hypothetical and for illustrative purposes only and do not represent the performance of any Lord Abbett product or specific investment. It is intended to provide general education and is not intended to serve as the primary or sole basis for your investment or tax-planning decisions. Please keep in mind that the hypothetical values do not reflect the fees and charges associated with specific investment products. If included, results would be lower.

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

Adjusted gross income (AGI) is a measure of income used to determine how much of your income is taxable. AGI is calculated as your gross income from taxable sources minus allowable deductions, such as unreimbursed business expenses, medical expenses, alimony, and deductible retirement plan contributions.

Required Minimum distributions (RMDs) must be taken from traditional IRAs by April 1 following the year that a person turns70½. A minimum distribution must be taken from the IRA in each subsequent year. Failure to take the RMD will result in a 50% penalty on the amount that was not distributed. Mandatory distributions that represent deductible contributions and all earnings are taxed as ordinary income. Mandatory distributions based on nondeductible contributions are tax-free.

The Tax Increase Prevention and Reconciliation Act eliminates income limits on conversions of traditional IRAs to Roth IRAs after 2009. If the conversion took place in 2010, income could be reported ratably in 2011 and 2012 on the amount converted. If the conversion takes place in 2012 or beyond, taxes on the taxable portion of the amount converted are due in the conversion year.

A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (reduction) contributions on a pretax or aftertax basis. Earnings accrue on a tax-deferred basis.

A 403(b) is a retirement plan for certain employees of public schools and tax-exempt organizations and certain ministers. Generally, retirement income accounts can invest in either annuities or mutual funds. Also known as a tax-sheltered annuity (TSA) plan.

A 457(b) is a nonqualified, deferred-compensation plan established by state and local governments, tax-exempt governments, and tax-exempt employers. Eligible employees are allowed to make salary deferral contributions to the 457 plan. Earnings grow on a tax-deferred basis, and contributions are not taxed until the assets are distributed from the plan.

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 SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

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