Retirement savers benefit from flexibility
Usually, in the tax and financial world, you cannot change a transaction and pretend it never happened. Once you make your decision, you have to live with it, for better or worse. But there is a notable exception for retirement-savers: When it suits your purposes, you can “recharacterize” a Roth IRA conversion.
In other words, if you converted funds in a traditional IRA to a Roth last year, you can reverse the conversion as if it did not occur, no questions asked. And you have until the extended deadline for filing your 2014 tax return—October 15, 2015—to make this maneuver.
Background: The annual contribution limit for traditional and Roth IRAs is the same. For 2015, the limit is $5,500 per person, or $6,500 if you are age 50 or older. Although traditional IRA contributions may be partially or wholly tax-deductible, distributions are generally taxed at ordinary income tax rates. Conversely, you can never deduct contributions to a Roth, but qualified distributions, such as those made at age 59½, are completely tax-free five years after setting up the account. Plus, you don’t have to take mandatory lifetime distributions after age 70½ as you do with a traditional IRA.
When you convert to a Roth, the value of the funds transferred to your new account is taxed just like a regular distribution from a traditional IRA. Therefore, if you convert funds this year, the tax will be due on your 2015 return, but you are in line for future tax-free benefits (assuming no legislative changes).
However, there is a time and a place for a recharacterization. Here are a few common examples.
- The value of the funds has declined since the conversion, so you have effectively overpaid the tax liability.
- The amount of the conversion tax caught you by surprise and you cannot afford to pay the IRS.
- You simply decided that the Roth conversion is not the best approach for your situation.
If any of these is the case, you can choose to recharacterize the Roth back into a traditional IRA by the tax return due date for the year of the conversion, plus extensions (i.e., October 15, 2015, for a conversion in 2014). This extended deadline generally gives you plenty of time to figure out the best course of action.
Note: You can reconvert back to a Roth if it suits your needs. The earliest date allowed for a reconversion is the later of either (1) the beginning of the tax year following the tax year of the conversion or (2) the end of the 30-day period beginning on the day of the recharacterization.
As you can see, the rules for recharacterizations and reconversions provide flexibility for retirement savers. Consult a professional adviser.