Way back in the good old days (prior to 2018) you could undo a Roth conversion. But not anymore. Here’s why that may be very important to your retirement.
What is a Roth Conversion?
A Roth conversion is when you take a portion of an IRA (or SEP, 401k, etc) and convert it into a Roth IRA. This act is a taxable event as the amount converted is (generally) claimed as income and must have tax paid against it.
Made Easy Explanation:
I say “generally” because it is possible that a person could have some IRA contributions that were not deductible originally, i.e. you already paid income tax on those IRA contributions. You wouldn’t have to pay income taxes again on those non-deductible IRA contributions that are counted toward the Roth conversion.
The simplest way to describe a Roth IRA conversion is essentially paying the tax on the converted amount, so that you won’t have to pay taxes on it in the future, nor pay taxes on growth in the future if you follow the rules properly.
What is a Roth Conversion Recharacterization?
A Roth conversion recharacterization is something that is no longer allowed. But when it was allowed it was the act of undoing the Roth conversion. If you found that you had converted too much from your IRA into your Roth IRA and you were now in a higher tax bracket than you wanted to be in, you could undo that conversion by recharacterizing some (or all) of it back into an IRA.
This of course is no longer allowed per the Tax Cuts and Job Act of 2017. Any Roth conversions that occurred on or after January 1, 2018 became permanent.
Made Easy Example:
Back in November 2016 Jane converted $100,000 from her Traditional IRA into her Roth IRA. Therefore, she claimed that $100,000 as income for the taxable year 2016. When her accountant was preparing her taxes in April of 2017 he noticed that the additional $100,000 put her into a higher marginal tax bracket than she had anticipated. But if she recharacterized $30,000 of the conversion, so that she only claimed an additional $70,000 in income for tax year 2016, that would put her back into a more acceptable marginal tax bracket.
Why Do A Roth Conversion?
The big question is “Why do a Roth IRA conversion in the first place?”
There are a couple of potential benefits.
Roth IRA’s eliminate “tax speculation.” No one can be certain of what tax rates will be in the future. We can look at clues that may point to it, like the growing federal debt, the large federal deficit that keeps the debt growing, the increase in people eligible for Social Security that must be funded, and perhaps even more importantly, the increase in people becoming eligible for Medicare which is funded with current taxation.
There are also of course other factors working in the different direction, such as the political difficulty of raising taxes too much and what it means for an individual politician’s ability to get re-elected, or even the entire political party’s future if they are the ones advocating tax increases. Also, higher tax rates are often applied to people with higher incomes, so how much will this impact people that have smaller IRA’s whose withdrawals won’t generate much income in any given year?
We can only speculate on this.
But Roth IRA’s give much more tax certainty going forward: 0% tax on withdrawals, if the rules are followed.
Another reason to consider converting is to have access to a larger pool of funds for large lump sum purchases that won’t push you into a higher tax bracket.
Sure, under ideal circumstances a Roth IRA should be the most coveted of your accounts, but if you wanted to make a large purchase, like an RV, pulling that large lump sum from a traditional IRA could boost your tax bracket up real quick. A Roth IRA may help in that situation, even if your large purchase is not an RV but something that is less discretionary.
Also, Roth IRA’s do not have required minimum distributions like IRA’s do. So you can keep them growing with no distributions even beyond age 72.
Another reason, to enhance the estate left to your heirs. They will also get the benefit of tax-free funds when they inherit your Roth IRA. This can be very important if your heirs are in their high income earning years when you pass away, as is often the case.
If you have irregular income and are in a low earning year, you may want to take advantage of being in a lower tax bracket and convert. This could be very applicable for business owners who see fluctuations in income. Especially in 2020 due to COVID.
And for that matter it may even apply to employees of companies in 2020 who experienced layoffs, furloughs or cut back hours due to COVID.
What If I Converted Too Much Into My Roth?
Since you can’t recharacterize your Roth conversions anymore, let’s go over the consequences of converting too much.
You could potentially be put into a higher tax bracket.
A conversion at a marginal tax rate of 24% may sound ok to you. But if you convert too much and cross the threshold into the 32% marginal tax bracket you may feel that is too high. Everyone is different on how they feel about which level of taxation that are comfortable reaching on a conversion.
There are also “cliff penalties” for income that exceeds certain levels. For instance, if your income exceeds a certain threshold you may pay more for your Medicare Part B premium and an additional amount on any Medicare Part D drug plan. This is known as the income-related monthly adjustment amount, or IRMAA. Even if you exceed this threshold by $1 the penalty is applied to you.
Generally anything associated with having a higher income can come into play. Because any amount you convert from an IRA (excluding the amounts that were non-deductible IRA contributions) will count as income in that tax year.
What Should I Do Before I Do A Roth Conversion?
Since you can no longer undo a Roth IRA conversion, the name of the game is proper planning and prevention.
This means understanding what your income has been during the taxable year. And then working with a tax advisor or your financial planner to understand the impact claiming additional income through a conversion will have on your overall situation.
Keep an eye out for “cliff penalties” like the Medicare IRMAA. Once you cross that threshold, even by $1, the penalty applies to you.
If you have irregular, or unpredictable income, it may make more sense to consider Roth IRA conversions later in the year after most of your income is accounted for, and any new unexpected income earnings are less likely.
Conclusion
Roth conversions can no longer be recharacterized. There are still many reasons to consider doing Roth conversions depending on your situation. Make sure you have done your homework or are working with a professional that can help you make better decisions on if you should convert and how much you should convert.
Chris Hammond
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