The rules will change–and not for the better–in 2018, assuming the Tax Cuts and Job Act passes.
Under current law, a contribution to a Roth IRA can be re-characterized as a contribution to traditional IRA and vice versa. This is accomplished by making a trustee-to-trustee transfer to the other type of IRA before the due date (including extension) of the taxpayer’s return for the taxable year in which the contribution occurs.
The rule applies not just to IRA contributions, but also to conversions. Thus, a taxpayer who converts a traditional IRA to a Roth IRA has until October 15 of the following year to determine whether the conversion (and the associated triggering of income tax) was a good idea.
If the account grows in value between the conversion and the due date of the income tax return, the conversion would normally be judged as a success. In that case, the taxpayer would pay income tax on the amount converted (and not its appreciated value). If the account declines in value over the same time period, the conversion would normally be judged as unsuccessful, in part because the taxpayer would be responsible for income tax on the value at the time of conversion, rather than its lower subsequent value. Thus, the taxpayer would unwind the conversion by re-characterizing the conversion as a contribution to a traditional IRA instead.
Starting in 2018, the ability to unwind a Roth IRA conversion will no longer be available. Under the Tax Cuts and Jobs Act, the special rule that allows a contribution to one type of IRA to be re-characterized as a contribution to the other type of IRA will NOT apply to a conversion contribution to a Roth IRA. Thus, re-characterization cannot be used to unwind an unsuccessful Roth conversion.
However, re-characterization is still permitted with respect to other contributions. For example, an individual may make a contribution for a year to a Roth IRA and, before the due date for the individual’s income tax return for that year, re-characterize it as a contribution to a traditional IRA. In addition, an individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, but the provision precludes the individual from later unwinding the conversion through a re-characterization.
Accordingly, this may be your last chance to do a risk-free conversion of a traditional IRA (or part thereof) to a Roth IRA.
For more on the Tax Cuts and Jobs Act, click here.
Posted by: Joel D. Roettger, JD, LLM, EPLS