Investor Education | Redemption for a Roth conversion
In the financial world, you usually are not afforded a second chance to improve the outcome of an investment decision. But you do have a unique opportunity if you converted funds in a traditional IRA to a Roth IRA. If it suits your purposes, you may also undo the conversion and recharacterize the Roth as a traditional IRA, as if the conversion never occurred.
The most common reason for a recharacterization is a situation where the value of the account has dropped since the time of the conversion. For instance, you may have converted to a Roth just prior to August 24, 2015 when the Dow Jones plunged precipitously. Fortunately, you have until the due date for filing your 2015 return plus extensions— October 17, 2016— to avoid the damage.
Background: The annual contribution limit for traditional and Roth IRAs is the same. For 2015 returns filed in 2016, the limit is $5,500 per person or $6,500 if you are age 50 or older. Although traditional IRA contributions may be partially or wholly tax-deductible, distributions are generally taxed at ordinary income tax rates. Conversely, you cannot deduct contributions to a Roth, but qualified distributions, such as those made after age 59½ are completely tax-free five years after setting up the account. Plus, you don’t have to take mandatory lifetime distributions after age 70½ as you do with a traditional IRA.
When you convert to a Roth, the value of the funds transferred to your new account is taxed just like a regular distribution from a traditional IRA. Therefore, if you converted funds in 2015 to a Roth, the tax is due on your 2015 return, but you are in line for future tax-free benefits (assuming that there are no legislative changes from Congress).
However, you may have chosen to convert at an inopportune time and now would like to rectify matters.
Example: You converted $100,000 to a Roth in 2015. But now those assets are worth $75,000, so you owe a higher tax than you would be liable for if you had waited to convert today. For instance, if the conversion is taxable at the 33% rate, you effectively overpaid by $8,250 ($33% of $25,000). In this case, you might choose to recharacterize the Roth. The extended due date of October 17, 2016, gives you plenty of time to figure out the best course of action.
Finally, you may reconvert back to a Roth when that is preferred, after the time has elapsed. The earliest date allowed for a reconversion is the later of the beginning of the tax year following the tax year of the conversion and the end of the 30-day period beginning on the day of the recharacterization.
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Investment Consultant
Tam Hubert, CFP®, CFA
Investment Assistant
Kristi Remus
