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.
How?
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.
You convert.
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.
Why?
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.
