With Tax Reform Uncertainty, Roth Conversions Need a Tremendous Amount of Confidence

David M. Barral, CPA/PFS, CFP
Published Date:
Dec 1, 2017

Tax reform has been on every tax professional’s mind—even more so as we approach year-end. Without any certainty of where we’re heading and when any changes will take effect, tax planning for clients has become increasingly difficult. It is a particularly difficult decision for those contemplating a Roth conversion, which can carry with it a hefty tax bill. Going forward, recharacterizations might also no longer be available under proposed legislation.

Roth conversions are ideal when they do not cost much in taxes for the taxpayer. This might be especially true for years when the taxpayer experiences net operating losses or much lower taxable income due to business start-up expenses. Then there are other situations, where the taxpayer is neither in the top nor lowest tax bracket, but just wants to benefit from long-term Roth account growth. The taxpayer has a long time horizon before any IRA distributions are required to be taken, and he or she wants to take advantage of qualified distributions from the Roth account later in retirement.

Qualified distributions from a Roth IRA are nontaxable distributions if made after the fifth taxable year during which the taxpayer made his or her initial Roth contribution. It must also be made after the owner reaches age 59 1/2, on account of the owner’s disability or death, or for a first-time home purchase (up to $10,000).

In prior years, Roth conversions could be performed, and if it turned out to be a bad decision, one could recharacterize. Recharacterizations allow taxpayers to change the nature of a contribution from one type of IRA to another. They apply to traditional contributions, so taxpayers could treat a contribution to a Roth IRA as a contribution to a traditional IRA, and vice versa.

Recharacterizations can also be done for conversions—that is, traditional IRAs that were converted to Roths during the year.

If a taxpayer makes a conversion from a traditional IRA to a Roth, he or she has the option to recharacterize it back to a traditional IRA, undoing the Roth conversion. This can be done for recharacterizations of employer plan distributions too; however, the money cannot go back into the employer plan—it must go into a new or existing traditional IRA.

The effect under Treasury Regulations section 1.408-5 (Q&A 3) is that the contribution being recharacterized as a contribution to the second IRA is treated as having been originally contributed to the second IRA on the same date and for the same taxable year that the contribution was made to the first IRA. This essentially allows the taxpayer to undo his or her conversion for Year 1 in Year 2, allowing him or her to monitor the tax effect for close to two years.

The benefit of recharacterizations is that they can be completed by the extended due date for the taxable year (IRC section 408A(d)(7)) and Treasury Regulations section 1.408-5 (Q&A-1(b)). A Roth conversion made in December 2017, for example, can be recharacterized in 2017 before the year-end or as late as Oct. 15, 2018. This allows taxpayers to monitor the conversion made in Year 1, and if Year 2 appears more advantageous, they can undo the Year 1 conversion in the following year.

The IRC does not allow taxpayers to only undo just the transaction with a recharacterization, but to also try again in the second year with a reconversion—however, taxpayers must wait until the later of 30 days after the recharacterization or the beginning of the tax year following the first Roth conversion. This rule prevents taxpayers from recharacterizing and then immediately reconverting and forces them to be in the market for at least 30 days—or even longer if the recharacterization was made early in the first tax year.

Example: Judith makes a Roth conversion in January 2017. If she decides to recharacterize in 2017, she’ll only be able to reconvert in 2018. If, however, Judith decides to recharacterize her 2017 conversion on Jan. 15, 2018, then she’d have to wait 30 days to reconvert again.

Recharacterizations are common when a taxpayer makes a conversion only to have the account value significantly drop in the following year. Because they paid tax on the fair market value at the date of conversion, they’ve essentially paid tax on evaporated income. Recharacterizations also make sense in the wake of tax reform uncertainty too because they can be made and then undone in the second year. The dilemma tax professionals are facing now, is that the proposed act (section 1501) would repeal the current law provisions for recharacterizations under IRC section 408A(6), which permits recharacterizations as late as the extended due date (Oct. 15, 2018).

What is unclear at the date of this writing, however, is if the proposed legislation will bar any recharacterization after Dec. 31, 2017. The coordination between current 2017 tax law and 2018 proposed law is a bit uncertain. Proposed laws could potentially remove the possibility of recharacterizing any conversion in 2018 for a 2017 Roth conversion. Tax professionals also need to weigh in the benefit of any state income tax deduction or savings attributed to the Roth conversion itself, which will still be permitted in 2017. Proposed legislation is looking to remove the state income tax deduction as well as alternative minimum tax, so professionals also need to consider if their client is susceptible to alternative minimum tax due to state income taxes paid on a conversion as well. 

What does this mean for tax professionals? Tax professionals need a tremendous amount of confidence that a Roth conversion makes sense because under the proposed law, they might not be able to recharacterize it back to a traditional IRA. All 2017 conversions might be final. 

barralDavid M. Barral, CPA/PFS, CFP, is a senior financial planning associate at Mariner Wealth Advisors in New York, N.Y. He is a member of the NYSSCPA Personal Financial Planning Committee, as well as its vice chair. He is also an adjunct professor at Wagner College in Staten Island, N.Y. He can be reached at david.barral@marinerwealthadvisors.com

Views expressed in articles published in Tax Stringer are the authors' only and are not to be attributed to the publication, its editors, the NYSSCPA or FAE, or their directors, officers, or employees, unless expressly so stated. Articles contain information believed by the authors to be accurate, but the publisher, editors and authors are not engaged in redering legal, accounting or other professional services. If specific professional advice or assistance is required, the services of a competent professional should be sought.