Sunday, January 28, 2018
Roth IRA Recharacterizations Are Going Away
You may have heard that there has been a tax change in the land of Roth IRAs. It is true, and the change concerns recharacterizations.
And what does that seven-syllable word mean?
Let’s say that you have $50,000 in a traditional (or “Trad”) IRA. “Traditional” means that you got to deduct the money when you put it in. You did so over several years, and you now have – after compounding - $50 grand. Congrats.
You read that this thing is a tax bomb waiting to go off.
Simple. It will be taxable income when you take it out. That is the bargain with the government: they give you the deduction now and you give them the tax later.
You decide to convert your “Trad” into a Roth. That way, you do not pay tax later when you take the money out.
You find out that it is pretty easy to convert, irrespective of what you hear on radio commercials. Let’s say your money is with Vanguard or T Rowe Price. Well, you call Vanguard or T Rowe and explain what you are up to. They will explain that you need a Roth IRA account. You will then have two IRA accounts:
CTG Reader Traditional IRA, and
CTG Reader Roth IRA
There is $50 grand in the Traditional IRA account.
There is now $50 grand in the Roth IRA and $-0- in the Traditional IRA accounts.
You did it. Good job.
BTW you just created $50 grand of taxable income for yourself.
How? Well, you converted money from an IRA that would be taxable someday to an IRA that will not be taxable someday. The government wants its money someday, and that someday is today.
You didn’t think the government would go away, did you?
Let’s walk this thing forward. Say that we go into next year and your Roth IRA starts tanking. It goes to $47 grand, then $44 grand. The thing is taking on water.
It is time to do your taxes. You and I are talking. We talk about that $50 grand conversion. You tell me about your fund or ETF slipping. I tell you that we are extending your return.
That is what changed with the new law.
For years you have had until the date you (properly) file your return to “undo” that $50 grand conversion. That is why I want to extend your return: instead of having to decide on April 15, extending lets you wait until October 15 to decide. You have another six months to see what that mutual fund or ETF does.
Let's say that we wait until October 8th and the thing has stabilized at $43 grand.
You feel like a chump paying tax on $50 grand when it is only worth $43 grand.
I have you call Vanguard or T Rowe and have them move that money back into CTG Reader Traditional IRA. Mind you, this has to be done by October 15 as the tax extension will run out. We file your return by October 15, and it does NOT show the $50 grand as income.
Why? You unwound the transaction by moving the money back to the Traditional account. Think of it as a mulligan. The nerd term for what we did is “recharacterization.”
It is a nice safety valve to have.
But we will soon have recharacterizations no more. To be accurate, we still have it for 2017 returns but it goes away for later tax years. Your 2017 return can be extended until October 15, 2018, so October 15, 2018 will be extinction day for recharacterizations. It will just be a memory, like income averaging.
BTW there is a variation on the above that will continue to exist, but it is only a distant cousin of what we discussed. Let’s go to your 2018 tax return. In March, 2019 you put $5,500 in a Roth IRA. You will still be able to reverse that $5,500 back to a regular IRA by October 15, 2019 (remember to extend!).
But the difference is that the distant cousin is for one year’s contribution only. You will not be able to take a chunk of money that you have accumulated over years, roll it from a Trad to a Roth and have the option to recharacterize back to a Trad in case the stock market goes wobbly.
Sad in a way.