Converting a traditional IRA to a Roth IRA can leave clients with a hefty tax bill. However, advisors should take note: A conversion can be reversed after the fact, in part or in full, to help clients lighten their tax load.
The challenge, according to Gary Plessl, co-founder of Houser & Plessl Wealth Management Group in Allentown, Pa., is that clients convert a traditional IRA to a Roth IRA during one year but then report the conversion on a tax return prepared the following year. “Therefore,” he says, “clients will do the conversions before they know exactly what their tax return will look like for that year. The IRS provides a great tool to work around this issue: recharacterization, which allows taxpayers to undo a portion of the, or the entire, Roth IRA conversion.”
This reversal can take place as late as Oct. 15 of the year after the conversion. A Roth IRA conversion generates an immediate tax on the pretax money moved from the traditional IRA; prepaying the income tax may be worthwhile because all Roth IRA distributions are tax-free after five years and age 59 ½. A Roth IRA recharacterization strategy can help in managing poor market performance after the conversion.
“We look at any Roth IRA conversions that clients have done during the previous calendar year to see if the amount has dropped in value,” says Carl Camp, president of Eclectic Associates, a planning firm in Fullerton, Calif. “If it has, we consider whether it is worthwhile to do the recharacterization.”
As an example, let’s say Joe Client converted a $200,000 traditional IRA to a Roth IRA in 2015, only to see a 20% loss in 2016. Joe may not want to pay tax on a $200,000 conversion in order to have a $160,000 Roth IRA. In that case, Joe can recharacterize the entire transaction, bringing the money back into a traditional IRA and avoiding any income tax on the conversion. Thirty days later, Joe can reconvert, perhaps paying tax on $160,000 of income rather than on $200,000.
FILLING THE BRACKET
Just as clients can convert part of a traditional IRA to a Roth IRA, they also can execute partial recharacterizations. “We typically suggest that clients consider converting money from a traditional IRA to Roth IRA if that money will be taxed in the 15% marginal tax bracket or lower,” Plessl says. For 2015, a married couple filing jointly can have taxable income up to $74,900 and stay in the 15% marginal bracket. Taxable income is calculated after deductions, so moderate-income couples, including retirees without earned income, might qualify.
“Ideally,” Plessl says, “we want to max out the 15% bracket and have the client’s return show taxable income of $74,900. When we are doing our tax-return estimates, we always try to convert more rather than less, in order to be sure we do not miss any opportunities to convert at a low tax rate.”
Suppose, when a draft of the client’s tax return is prepared in early 2016, the actual taxable income is $80,000 with a full Roth IRA conversion. “If so,” Plessl says, “$5,100 of the conversion [the difference between $80,000 of taxable income and the $74,900 ceiling of the 15% bracket] would be taxed in the next marginal bracket of 25%, which we do not want. Recharacterization gives us the opportunity to ‘undo’ $5,100 of the conversion. Once the recharacterization is done, we adjust the clients’ tax return before filing it, so their taxable income becomes $74,900. We have completely maxed out the 15% marginal tax bracket without going into the 25% bracket.”
Higher-income clients also might benefit from this approach. “We had a client whose income for the year of a Roth IRA conversion turned out to be much higher than anticipated,” says Sheryl Rowling, principal of Rowling & Associates, an advisory firm in San Diego. “We recharacterized a portion of the conversion to lower the effective tax rate.”
Cheryl Holland, president of Abacus Planning Group in Columbia, S.C., also uses recharacterization to fine-tune clients’ tax outcomes. “We convert to Roth IRAs opportunistically,” she says. “A client might have a low-tax year because of high medical expenses. Retired clients may consistently have depressed income.”
For such clients, her firm estimates how much of a Roth IRA conversion they can do in the low tax bracket.
“In the year after a Roth IRA conversion,” she says, “around the beginning of April and the beginning of October, we look at clients’ draft tax returns to see how much of the Roth IRA conversion to keep in order to hit the top of the tax bracket. Then we’ll recharacterize the excess amount.”
Why look in April if the final deadline is Oct. 15? Many clients “don’t like the idea of filing in April and then filing an amended return in October to recharacterize a Roth IRA conversion,” Holland says. Other clients are willing to wait until the October deadline.
Another recharacterization-based tactic is to convert a traditional IRA to two or more Roth IRAs, each holding different investments. When the recharacterization deadline nears, losers may be reversed without jeopardizing potentially tax-free gains from the winners. A $100,000 IRA might be converted into a $50,000 domestic equity Roth and a $50,000 international equity Roth. By the recharacterization deadline, the laggard might be reversed to save tax, while the leader is kept in place.
“If a material amount is involved, we will break up the conversion into two or three different Roth IRAs, with a different investment subclass in each one,” Rowling says.
“For example,” she continues, “we converted a client’s $300,000 IRA to three $100,000 Roth IRAs: one for emerging markets equity, one for U.S. small-cap and one for international small-cap. One of those Roth IRAs has come down, so we recharacterized it.”
Holland also tells of a client who converted into three Roth IRAs, one for domestic equities, one for international equities and one for real assets. She notes, however, that this was an unusual move: “Most of our clients don’t want to convert a traditional IRA to multiple Roth IRA accounts, then recharacterize, reconvert and so on.”
Rowling, however, says her clients are “very happy” with such maneuvers. “For many of them,” she says, “their No. 1 issue is that they hate to pay taxes. They want to know that we’re looking out for them in that area.”
PROCEED WITH CAUTION
Although recharacterizing after a decline in Roth IRA value may offer tax advantages, the decision is not automatic. “That depends on how steep the drop has been,” says Holland. “Also, if a client’s tax rate is unusually low for the year, we might keep the Roth IRA conversion in place, despite the lower value.”
Camp says having a Roth IRA may offer added benefits.
“Some of our clients have almost all of their assets, other than their home, in retirement accounts that are subject to taxation when money is withdrawn,” Camp says. “If they can have some money in accounts that have already been taxed, like a Roth IRA, it gives them flexibility when money must be withdrawn from investments. Years after the conversion, we might choose to take money out of the Roth IRA or the traditional IRA, depending on their tax situation for the year. This desire to have some accounts with money that’s already been taxed may cause us not to recharacterize, even though the Roth IRA has lost some value.”
Donald Jay Korn is a contributing writer for Financial Planning and also writes regularly for On Wall Street.
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