New Roth IRA Recharacterization Rule

A major change to the tax rules starting in 2018 could leave many paying high taxes on investments that they have lost money on. The new tax law prevents recharacterizations of Roth IRA conversions made starting this year. Going forward, you’re stuck with the tax consequences even if the market drops afterwards.

Converting your traditional IRA to a Roth IRA may still make sense for some. Going forward, investors will need to be better informed about making a Roth conversion. This means they will need to understand how a conversion works and the potential issues the rule change could cause. They will also need to have an informed understanding of where the market may be headed in the future.

Individual Retirement Accounts

Traditional and Roth IRAs have different tax structures. With a traditional IRA, the money you contribute today reduces your current year taxable income. Growth is tax sheltered until you withdraw funds. At that time, you will pay ordinary income taxes. A Roth IRA does not allow current year tax deductions, but it offers the same tax-sheltered growth and tax-free distributions. Withdrawals made prior to age 59 ½ may be penalized.

You can currently contribute $5,500 ($6,500 if your over the age of 50) to either of these retirement accounts as long as your income falls within the contributions guidelines. There are pros and cons for each of these retirement accounts. Typically, I recommend that clients with lower incomes use the Roth plan to take advantage of their currently lower tax bracket. For higher income clients, a traditional structure can help reduce some of their tax burden.

Traditional IRA vs Roth

Reasons to Convert

If you have a traditional IRA, there may be a time when converting all or a portion of the account to a Roth IRA makes sense. Traditional IRAs have been around longer than Roth IRAs, which means that many investors started saving for retirement under a traditional plan. Doing a Roth conversion can allow an investor to move a larger amount of funds into the Roth IRA than what additional contributions alone would permit.

Having both types of these IRAs allows one to create a retirement strategy with both taxable and tax-free income. This allows you to coordinate withdrawals during retirement that minimize taxes and reduces the chance of Social Security benefits becoming taxable. Roth IRA’s are not subject to the Required Minimum Distribution rules that requires withdrawals begin at age 70 ½. That allows continued tax sheltered investment growth. Finally, considering we’re at historically low tax rates, it may be beneficial to take advantage of paying taxes now rather than chancing higher rates later on.

Roth IRA Conversion

Converting from a traditional IRA to a Roth IRA is fairly simple. In years past, conversions were restricted based on income. The IRS has removed that limitation. Now, a conversion can be done in any amount by simply moving funds to a Roth IRA. This can be done with a 60-day rollover from the traditional to Roth IRA, a trustee to trustee transfer, or a same trustee rollover.

The amount of the conversion is considered taxable income for the year. Unlike other distributions from a traditional IRA, there is no 10% premature distribution penalty if the conversion is made prior to age 59 ½. The conversion is reported on Form 8606.

A conversion in best done near the end of the year for two reasons. The first is that it allows one to have a better idea of their tax situation. The second reason is the Roth IRA’s five-year rule. The rule requires that distributions from a Roth IRA be made five years after the owner established and funded the account in order to remain qualified and penalty free. A Roth IRA conversion is considered to take place on January 1st, no matter which date it actually occurred.  

New Rule for Roth Recharacterizations

The Tax Cuts and Jobs Act of 2017 was touted as an overhaul of the tax code, but the reality is that it’s move of an overlay to the previous rules. What that means for most is that the tax code now contains added additional complexity. Some changes are beneficial, others are not. The new rule that prevents Roth IRA recharacterizations is a one that will create financial pain in the future.

Prior to 2018, if someone wanted to change their Roth conversion back to a traditional IRA, they could. If someone converted to a Roth IRA, they could move back before the tax filing deadline. With extensions, that deadline was October 15th in the year after your conversion took place. As of 2018, you are no longer able to do this after a Roth conversion.

The New Risk of Roth Conversions

Limiting recharacterizations will cause people to pay taxes on investments that have lost money. That might not be an issue while the market rises, but the impact will be severe during a recession. Let’s look at how this rule would have impacted an investor during the Great Recession of 2008.

As an example, let’s say that an investor converted $100,000 from their traditional IRA into a new Roth account at the end of the year in 2007. The investor, who is Married Filing Jointly, adds this $100,000 to their household income of $75,000 for the year. The extra income from the conversion would have been taxed in both the 25% and 28% tax brackets.

As part of the conversion, the investor moves their investment in the SPDR S&P 500 ETF (SPY) fund over on December 31st. On that that day, SPY is trading for $147.10 a share.  We all know what took place next. The market goes into freefall. By the recharacterization deadline, SPY is trading at $97.46 a share. The $100,000 investment is now worth $66,242.

Now imagine that the investor, like many others, lost their job and now needs to access their investments in order to survive. Under to old rule, they could recharacterize the conversion back in order to avoid realizing the extra taxable gain. Under the new tax law, they’re stuck paying the extra $26,377 in taxes. That’s on top of the $33,758 loss they suffered on the investment.

Planning Considerations

Moving forward, Roth conversions needs to be carefully considered. Prior to this change, a client’s taxable situation needed to be carefully understood before making changes. This included understanding their current year tax situation as well as estimating future year liabilities. With the change, one most also consider the near term economic conditions that could impact the stock market.

Our current near term economic conditions seem positive. Then again, did anyone predict on December 31st, 2007 predict what would happen the following year? If they’d those predictions… did anyone listen? Keep in mind, the same climate of deregulation and tax cuts we’re in now were, in part, to blame for the Great Recession.

If there is one main takeaway from this article, it should be that this decision to convert should be made with the consultation of a financial professional. Making a mistake prior to the rule change was an easy fix. Going forward, you’re stuck with the change. A Roth conversion should only be done once you have the best information available at the time.


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