Before 2018, self-directed IRA owners could choose to recharacterize or undo a conversion to their self-directed Roth IRA, up until their income tax-filing deadline for the year. (This means, for example, that if you converted assets in 2016, you would have had until October 15, 2017, to change your mind and reverse the conversion.) Tax reform changed these rules and eliminated this option, beginning for conversions made in 2018.
What is a conversion?
A conversion happens when a self-directed IRA owner chooses to move pre-tax retirement savings from a traditional IRA, SEP IRA, SIMPLE IRA or a retirement plan to a Roth IRA. (A SEP IRA is a traditional IRA that holds SEP plan contributions.) The pre-tax portion of the amount converted to a Roth IRA must be included in their taxable income for the year of the conversion. Once the assets are in the Roth IRA, they are “after-tax” assets and may be withdrawn tax-free.
A conversion may be made through a
- Direct movement from one IRA custodian to another
- Movement between IRAs with the same custodian
- Rollover from an IRA or retirement plan custodian to a Roth IRA custodian
There are a variety of reasons people choose to convert assets to a self-directed Roth IRA, including the benefit of tax-free growth on alternative investments held in a Roth IRA and tax-free distributions in retirement. If a Roth IRA owner does not need the money in retirement, they are not forced to take distributions because Roth IRAs are not subject to the age 70½ RMD rules. An IRA owner who is currently in a lower income tax bracket, but expects to be in a higher tax bracket in the future, may benefit from converting now, at the lower tax rate, rather than taking a taxable distribution from the traditional IRA sometime in the future. Additionally, some individuals are not eligible to contribute directly to a Roth IRA because of the income limits, so their path for funding a Roth IRA is through conversions since there are no income limits for conversions.
Why would I recharacterize a conversion?
In 2017 and prior years, IRA owners had the option to “undo” a conversion by recharacterizing it into a traditional IRA (or a SIMPLE IRA if that’s where it came from). To do this, they had to direct their IRA custodian to move the assets from the Roth IRA back to a traditional IRA, which would effectively change the assets back into a pre-tax status. IRA owners had to report these transactions to the IRS with the IRA owner’s tax return to explain why the conversion distribution was no longer taxable.
Taxpayers valued this safety net because it allowed them to change their minds about paying taxes on the dollars initially converted. For example, if the added amount of taxable income from the conversion put the IRA owner in a higher tax bracket, or they didn’t have the funds to pay the tax owed for the conversion, they could undo the conversion. Additionally, IRA owners could watch the performance of their investment in the self-directed Roth IRA during the year or so after the conversion. If the investment value decreased significantly, the IRA owner could undo the conversion, so they were not stuck paying taxes on a conversion amount that was no longer as valuable as the amount they would have to recognize as taxable income. They could move the remaining assets back to a traditional IRA and un-do the conversion without penalty.
How have the rules changed?
While you can still convert pre-tax assets to a Roth IRA, you can no longer recharacterize a Roth conversion that occurred in 2018 or later. But the IRS has clarified that taxpayers may still recharacterize a 2017 conversion up until their tax return due date, plus extensions (typically October 15, 2018, if you file your taxes timely).
If you’re thinking about converting assets to a self-directed Roth IRA, make sure you understand the benefits and the tax impact before you complete the conversion. If the taxes are a concern, you may want to consider converting smaller amounts in multiple years instead of converting a large balance all at once.
You can still recharacterize a current-year (new) contribution if you change your mind about contributing to one type of IRA or another or if you find out you were not eligible to make the entire contribution to one type of IRA. For example, if you make an annual contribution for 2018 (up to $5,500, $6,500 if you’re age 50 or older) to a traditional or Roth IRA, you have until your 2018 tax-filing deadline plus extensions to recharacterize the contribution and any attributable earnings to the other type of IRA. Just be sure to complete the proper paperwork with your IRA custodian and reflect the proper contribution amount (and deduction if applicable) on your tax return.
To learn more about conversion and recharacterizations: