IRA Recharacterizations Past, Present, and After Tax Reform
Although it’s been touted that the modern IRS is friendlier, taxpayers have few opportunities to undo their poor tax-related decisions without suffering ill tax consequences. The 2017 tax reform legislation, described in the Ascensus® December 21, 2017, Washington Pulse, is now taking away a big undo from IRAs.
Individuals who do IRA conversions or retirement plan rollovers to Roth IRAs—both potentially having big tax hits—can no longer recharacterize, or undo, these transactions if they take place after December 31, 2017. But recharacterizations of current-year IRA contributions remain available.
Common Reasons for Recharacterizations
It often isn’t until IRA owners are working on their income tax returns that they discover they didn’t make the best decision. Here are some common reasons IRA owners historically might have elected recharacterizations.
- They discover their Traditional IRA contributions are not deductible because of their participation in employer-sponsored retirement plans and their amount of income.
- They learn their modified adjusted gross income (MAGI) is too high, making them ineligible for their Roth IRA contributions.
- They left their employer and decided to roll over their 401(k) plan money to a Roth IRA to take advantage of tax-free withdrawals in retirement, but were unaware that the rolled assets become taxable income in the year of rollover.
- They convert their Traditional IRA assets to a Roth IRA, not realizing that this also is a taxable event, and might even push them into a higher tax bracket.
Past and Present
These mistakes can be shocking to taxpayers, and the IRA rules have given them an opportunity to undo these transactions. Recharacterizations in the past have been a way to move current-year contributions or conversions, with the net income attributable (NIA), from one type of IRA to another, or to move retirement plan-to-Roth IRA rollovers, with NIA, to Traditional IRAs.
But this do-over is trimmed down as a result of tax reform legislation (Public Law 115-97) that was enacted late in 2017—recharacterizations of conversions and retirement plan rollovers to Roth IRAs are no longer allowed. But recharacterizations of regular IRA contributions remain an option.
IRS Says Can Recharacterize 2017 Transactions in 2018
The new rules are clear about conversions and retirement plan-to-Roth IRA rollovers that occur in 2018—they cannot be recharacterized. But whether conversions and retirement plan rollovers completed in 2017 can be recharacterized in 2018 is unanswered in the new statutory language. Ascensus® contacted an IRS official, who stated that the IRS is aware of this issue and that it will allow conversions and retirement plan rollovers completed in 2017 to be recharacterized in 2018. Then in January, the IRS released a question and answer article on their website, which states the IRS position that 2017 conversions (and retirement plan rollovers to Roth IRAs) can be recharacterized in 2018.
The deadline to complete a recharacterization is the taxpayer’s tax return due date, plus extensions, for the year for which the contribution or conversion was made. Those who file their federal tax returns by their tax filing deadline get an automatic six-month extension from the original due date to complete the recharacterization, bringing the recharacterization deadline to October 15 for most taxpayers. See IRS Publication 590-A, Contributions to Individual Retirement Arrangements, for more on recharacterizations.
Individuals considering conversions or retirement plan rollovers to Roth IRAs going forward should carefully consider the new recharacterization restrictions. Ignorance is no longer an excuse for a too-hastily made decision with unanticipated tax consequences. Once the conversion or plan rollover is completed, it cannot be undone.