Last Chance to Recharacterize a Conversion

by Alayna Drope, CIS, CIP

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This October marks the end of two IRA transactions: 1) a recharacterization of a Traditional (or SIMPLE) IRA-to-Roth IRA conversion and 2) a recharacterization of a non-Roth retirement plan-to-Roth IRA rollover. Although it may be somewhat of a relief for financial organizations going forward not to deal with these two types of recharacterizations, they should still be prepared to discuss this change with their IRA owners who are planning to convert or roll over plan assets to a Roth IRA.

What Is a Recharacterization? 

A recharacterization is the movement of a current-year contribution with the net income attributable, from one type of IRA to another type of IRA. And for a little while yet, it also includes the movement of a Roth IRA conversion back to a Traditional IRA or a non-Roth retirement plan-to-Roth IRA rollover to a Traditional IRA. In essence, a recharacterization allows an IRA owner to “undo” the original transaction and instead treat the contribution, conversion, or rollover assets as though they were made to a different type of IRA.

No Longer Can You Have Your Cake and Eat It Too

For many years IRA owners enjoyed the luxury of converting (or rolling over non-Roth retirement plan assets to a Roth IRA), knowing that they could undo the transaction if they needed to. This allowed them to move more assets into a Roth IRA without worrying about market loss. If market loss did occur, they could easily recharacterize the conversion (or rollover) back to a Traditional IRA. And in the case of a conversion, after the appropriate waiting period, they could then reconvert the same assets, often leading to a lower tax burden for the IRA owner who converted. In other cases, IRA owners who did not fully understand the tax consequences of converting or rolling over to a Roth IRA could rely on a recharacterization to undo the transaction and avoid the tax burden. That will no longer be an option.

As described in the Ascensus® December 21, 2017, Washington Pulse, the Tax Cuts and Jobs Act of 2017 eliminated the ability to recharacterize conversions and retirement plan-to-Roth IRA rollovers, effective for taxable years beginning after December 31, 2017. Any 2017 conversions and retirement plan-to-Roth IRA rollovers, however, may be recharacterized to a Traditional IRA in 2018, up until the deadline. With an automatic six-month extension for those who filed their taxes timely, the deadline for most generally is October 15, 2018, making that the very last day to recharacterize a conversion or rollover.

Note that only recharacterizations of conversions or retirement plan rollovers to Roth IRAs will become obsolete. Financial organizations may continue to accept recharacterization requests for current-year Traditional or Roth IRA contributions. In this way, recharacterizations may continue to be a viable tax planning strategy. For instance, if a Traditional IRA owner makes a current year contribution and later realizes she is not able to deduct the contribution, but is eligible to make a Roth IRA contribution, she may recharacterize the contribution and consider it a current-year contribution to her Roth IRA, provided she completes the recharacterization by the applicable deadline. 

Educate IRA Owners

To prevent IRA owners from being caught off guard when faced with a tax dilemma after converting or rolling over plan assets to a Roth IRA and to aid in their understanding of the new rules, financial organizations should clearly outline the basic tax implications that may occur at the time of the transaction. By educating their IRA owners, organizations can help reduce instances of regret and frustration when a client realizes he can no longer undo a conversion or rollover to Roth IRA.

In addition, Ascensus strongly recommends that organizations amend their IRA disclosure statement for recent updates to increase client awareness about current laws. This is not an IRS requirement, but due to the far-reaching consequences of this tax law change and other recent tax law changes, providing an updated disclosure statement to all IRA owners ensures that an organization’s IRA program is compliant and up to date with current regulations.