Hitting ‘Undo’ On A Roth Conversion

15356444_sOver the past three years, we have discussed Roth IRAs a few times. We have reviewed what it means to have one, what the rules are that pertain to them, the implications of converting traditional IRAs to Roth IRAs and the possibility of re-characterizing those conversions. In light of the recent market volatility, I thought this would be an appropriate time to revisit the last topic, re-characterizations, because I want you to understand the analysis involved in determining when reclassifying a Roth conversion is appropriate.
There are basically two ways to save for retirement, with a tax-deferred strategy or a tax-exempt strategy. Examples of a tax-deferred strategies include Traditional IRAs and 401(k)s. Essentially, if we contribute to a Traditional IRA or 401(k), we do not pay any tax on what is being contributed. In other words, the contributions are pre-tax. In addition, our earnings grow tax-deferred. However, when funds are withdrawn from those accounts, all of that money is taxed as ordinary income. One of the premises supporting tax-deferred retirement savings is that when we switch from the accumulation phase of our financial lifecycle to the distribution phase, we will be in a lower tax bracket. Folks, from my experience, for most of us that premise is flawed. It begs the questions that I ask everyone who comes through my door, and that I ask you, Cutter Family Finance readers. Do you think taxes are going up in the future? I do!
Examples of tax-exempt strategies include Roth IRAs and Roth 401(k)s. While we do not get a tax break on the money contributed to Roth IRAs and Roth 401(k)s, all of our contributions and earnings can be withdrawn tax-free. Uncle Sam gets “boxed out” of collecting any future tax dollars from such accounts. (There are certain contribution and distribution rules specific to Roth accounts, that I don’t get into here, so make sure you check with your retirement specialist before choosing a strategy.)
Now, if we have converted to a Roth IRA, when does it make sense to re-characterize the conversion? That is our discussion for today.
This brings me to my new friend; let’s call him Danny. Danny found himself in that situation. Luckily for Danny (and for any of you) this is one of the few times when Uncle Sam gives you a do over. This “do over” is called a Roth re-characterization.
Danny attended a recent financial class that Susan and I taught at Cape Cod Community College and came to see me after class. Danny, at 55 years old, had converted $100,000 to a Roth IRA last year. Unfortunately for him, that Roth IRA was part of a buy and hold strategy that ended up in the tank by the end of 2015, with a 22 percent loss. As you know, Danny is required to pay ordinary income taxes on $100,000 (the value of the account at the time of the conversion), even though $22,000 of it was lost by year-end. So, let’s do some simple math. Danny is in the 25 percent tax bracket, so he will need to pay about $25,000 in taxes on the funds converted from his Traditional IRA to a Roth IRA. This figure, combined with his $22,000 loss, results in a $47,000 hit to a $100,000 conversion.
Hmm . . .
Danny was looking for a better solution. I mentioned the possibility of re-characterization. You see, not only are there considerations surrounding whether or not to convert to a Roth, once converted, there are considerations in determining whether to re-characterize a Roth back to a Traditional. One of those is performance, as evidenced by Danny’s situation. Between the tax hit and his portfolio’s performance, he could be out $47,000.
I went on to explain to Danny that there are a few additional situations where people can find themselves best served by re-characterizing. For example, when taxable income ends up being higher than expected, or the additional income that must be reported on from the conversion has bumped someone into a higher federal income tax bracket. The cost of this increase could be enough to support re-characterizing the conversion. The opposite can also be true when a person retires, and finds that his or her taxable income is lower than expected, so the benefit of tax-free distributions in retirement is not as beneficial as initially assumed. Some people even consider a re-characterization simply because they don’t have the cash available when it is time to pay the taxes.
Whatever the reason, if you find that a re-characterization is right for you, as I recommended for Danny, you need to make the move before filing your tax return for the previous year, which is usually April 15, or October 15 if you filed an extension.
It is important to note here that just because Danny re-characterized back to a Traditional, it does not exclude him from making conversions in future tax years.
So this tax season, if you made a Roth conversion last year and you have suffered losses in your portfolio, as Danny did, take some time to do the math. Like Danny, you may realize that a Roth conversion was appropriate at the time of the conversion, but by the end of the year, well, it turns out to be inappropriate. If you find yourself in this situation, don’t forget that you have options.
Be vigilant and stay alert, because you deserve more.