If you own or are thinking about starting a Roth IRA, you need to know that a major change is coming to Roth IRAs. Both the House and Senate proposals include this change.
Let me start by saying that I am a raving fan of Roth IRAs. They have many advantages over traditional IRAs.
If you have traditional IRAs or company retirement plans, once you reach age 70 1/2, the IRS requires you to begin withdrawing your money (whether you need it or not). Remember, taxes have never paid on any of the funds in traditional IRAs (unless you contributed with after-tax dollars). The IRS wants to get paid. Called required minimum distributions (RMDs), the IRS forces you to begin withdrawing money based on your life expectancy (as they determine it) for the rest of your life.
As I see it, the most significant advantage to Roth IRAs is you have no required minimum distributions at age 70 1/2. That provision puts you in control over when you take income.
If you make too much money to contribute to a Roth IRA, you can get money into a Roth via the Roth conversion. In a Roth conversion, you transfer (convert) money from traditional IRAs to Roth IRAs. This conversion creates a taxable event. Meaning, you pay taxes on the converted money. The tax is paid at your ordinary income tax rate, just as if you took the money in cash. Normally, if you were under age 59 1/2, you would pay a 10% penalty on top of the tax. However, in Roth conversions, the IRS waives the 10% penalty.
For some background on Roth conversions read Roth IRA Conversion Rules.
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Roth recharacterization (the do-over)
The current tax rules allow you to recharacterize your Roth conversion. Basically, it's a do-over. As far as the IRS is concerned, it's like the conversion never happened.
Under current tax law, if you convert a traditional IRA to a Roth IRA in 2017, you have until October 2018 to recharacterize (undo) this conversion. In a recharacterization, you move the converted money back into a traditional IRA, either the one from which it came or a new IRA. The custodians report the contribution and recharacterization amount to you and the IRS on form 5498 You get one form 5498 from the custodian of the traditional IRA for the distribution. A second comes from the custodian of the Roth IRA that received the contribution. The distribution and contribution offset each other. So you pay no net tax on the transaction.
There are many reasons why you would undo a Roth conversion. That discussion is outside the scope of this post. The Investopedia article, Recharacterizing Your IRA Contribution or Roth Conversion, offers a detailed look at the conversion rules.
Eliminating Roth recharacterization likely to survive
Both the GOP House and Senate tax reform proposals, introduce this major change to Roth IRA conversions. Essentially, the recharacterization option is no longer available. This is a game changer for anyone considering converting to a Roth IRA now or in future years.
The option to undo this conversion motivated many to convert in the first place. Tax rate changes, market changes, bad performance from specific investments were all good reasons to undo the conversion.
If you converted to a Roth in 2017, the option to recharacterize it before October 2018 is not available. However, you could still recharacterize before the end of 2017. If you miss the end of the year deadline, the option is gone in 2018.
It's hard to tell what the Tax Cuts and Jobs Act final product will look like. At the time of this writing, the House passed its version of the bill. The recent past indicates this bill may not make it through the House and Senate reconciliation process. If a bill does pass, however, it seems the elimination of the Roth recharacterization will survive.
Have you converted an IRA this year? If so, talk to your financial advisor or CPA to discuss whether it makes sense to undo it. This may be your last chance.
What do you think? Will tax reform pass this year? Will the Roth provision survive?
I welcome your comments and feedback.