Changes to Roth IRA Recharacterizations

Lavelle & Finn

For tax year 2018 and after, taxpayers can no longer recharacterize Roth IRA (individual retirement account) conversions under the new tax law.

There are three ways to contribute funds to a Roth IRA: a direct contribution, a rollover from a Roth 401(k) or 403(b), and a conversion from a regular IRA account.  There are limits on how much a taxpayer can directly contribute to a Roth IRA, so high income earners may not have that option.  The limit on contributions in 2018 is $5,500 ($6,500 for taxpayers aged 50 years and older).  This limit phases out, so that individuals having adjusted gross income over $135,000 cannot make direct contributions (the cutoff for married couples is $199,000).

Because high-income taxpayers are barred from directly contributing to a Roth IRA, the solution is to contribute to an IRA and then convert the funds to a Roth IRA (and pay the tax attributable to the Roth conversion).  This conversion must be accomplished by December 31.  What happens if the market crashes after a conversion and you now have to pay tax on value that has disappeared?  Or, you find yourself in an unexpectedly higher tax bracket than you planned for this conversion?   The old tax rules allowed taxpayers to undo (“recharacterize”) the conversion and send those funds back to the regular IRA and not pay the tax.  This helped prevent punishing taxpayers for ill-timed conversions or miscalculations.

The new tax law has prohibited recharacterizations starting in 2018.  Taxpayers may want to consider partial conversions rather than full conversions of their IRA funds.  However, if you did complete a Roth IRA conversion in 2017, don’t worry; the IRS has clarified that taxpayers can still recharacterize the 2017 conversion until October 15, 2018.