Taxpayers who converted a traditional IRA to a Roth IRA in 2013 can “undo” the conversion, but the deadline for doing so is October 15, 2014. Undoing the conversion is termed a “recharacterization;” the Roth IRA is recharacterized to a traditional IRA, generally with no tax consequences. A quick review of IRAs and Roth conversions shows why a taxpayer might consider recharacterizing a conversion done last year.
Quick Review of Traditional and Roth IRAs
Taxpayers can contribute the lesser of $5,500 ($6,500 if over age 50) or their taxable income to an IRA each year, and spouses are allowed to double the contribution amount. Contributions to a traditional IRA are deductible for income tax purposes, meaning the contributions come from pre-tax income. Growth inside a traditional IRA is tax-free until withdrawn, when the distribution is included in the taxpayer’s income. A traditional IRA is subject to required minimum distributions during lifetime. In contrast, contributions to Roth IRAs are made with after-tax dollars, meaning contributions are not deductible. However, when qualified distributions are taken in retirement, no tax is due. Roth IRAs are not subject to minimum required distributions until after the account holder’s death.
Roth Conversion Basics
In 2010 the income restrictions on converting a traditional IRA to a Roth IRA were lifted, making it available to more taxpayers. Because the Roth IRA also grows tax-free and results in tax-free distributions during retirement, many taxpayers opt to convert all or part of their traditional IRA to a Roth IRA. The conversion is accomplished by contributing a distribution from a traditional IRA to a Roth IRA account, or simply making a direct transfer from a traditional IRA account to a Roth IRA account. Conversion, however, comes at a price. Generally, the entire value of the converted IRA is taxed at ordinary income rates (and not the lower capital gain rates). The trade-off is to pay tax now in exchange for zero tax later which, for many taxpayers, is worth the cost of conversion.
Recharacterization (or Undoing the Conversion)
Taxpayers can recharacterize a conversion to a Roth IRA as a contribution to a traditional IRA if the taxpayer chooses. One reason a taxpayer may choose to recharacterize is that the IRA declined in value after conversion. The inflated value of the IRA on the date of conversion is what is included in gross income, meaning tax could be due on phantom income. Recharacterizing the contribution to the Roth IRA essentially treats the contribution as a rollover from one traditional IRA to another traditional IRA, and therefore, no tax consequences result. After recharacterization, the traditional IRA rules will once again apply to the account. Recharacterized 2013 assets may be reconverted after a 30 day waiting period this year.
Deadline to Recharacterize 2013 conversions
The deadline for recharacterizing a 2013 conversion is October 15, 2014 (which is the extended due date of the 2013 income tax return). A taxpayer can recharacterize even if the 2013 income tax return has already been filed. An amended return would be required. Contact your estate planning attorney at Sirote for more information on IRA conversion or recharacterization.