Why It's a Great Time to Convert Your Traditional IRA

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Roth IRA PebbleMarket corrections are an excellent time to consider converting traditional IRAs to Roth IRAs. A Roth conversion allows you to pay tax on asset values while they are low due to the market decline. All the gains will be potentially tax free when the market recovers.

Anyone is a good candidate for a Roth conversion, as long as they expect to remain in the same (or higher) tax bracket and can pay the taxes on the conversion from funds outside the Roth. Taxpayers who believe they will be in a lower tax bracket in 2016 and beyond should probably wait to execute a Roth conversion.

What makes a Roth conversion a good decision is generally 1) How long will the money remain in the Roth growing tax free? The longer it stays in the Roth, the more advantageous the conversion. 2) Can you convert the money in a lower tax bracket today than you expect to be in future years? Paying 15% tax today on a Roth conversion beats paying 25% later when you have to start taking required minimum distributions (RMDs).

You should consult a tax advisor or financial planner if you are considering a Roth conversion but will have to pay the taxes from part of the conversion. There could be other ways to satisfy the tax. A very important trap to keep in mind if you are considering paying the tax from the amount converted is your age. While Roth conversions are not subject to the 10% penalty if you are under age 59 ½, money withheld to pay taxes from an IRA is considered a distribution, which is subject to the 10% early withdrawal penalty.

What makes the Roth conversion such a great planning tool is the ability to reverse, or “recharacterize” (in tax speak), the transaction as late as October 15th of the year following the initial conversion. You can recharacterize all or a portion of the conversion until this deadline. You might recharacterize if you discover that your tax situation is actually better in 2016 or if the assets in the Roth you converted performed poorly. Congress could pass a major tax reform bill early next year that would provide lower tax rates across the board (don’t laugh, it could happen). No matter what the reason, you can press the undo button and there would be no tax implications.

There are a few important points to remember when recharacterizing. Recharacterization is calculated in dollars. The account owner must put back the same dollar value converted plus or minus the gain. The gain or loss to the entire account must be calculated to determine the amount for recharacterization. Not just the position converted. When done properly, the recharacterized funds are treated like they never left the IRA. There is no tax on any gain or deduction for loss that occurred while the funds were in the IRA. A recharacterization can be done in part. You do not have to recharacterize the entire conversion amount.

The deadline to complete the recharacterization is October 15th of the year after the year of the conversion. You can recharacterize even if a tax return has already been filed. The original return can be amended to claim a refund on the taxes paid on the conversion. You have three years to file an amended return but the recharacterization must be done by the deadline.

There is a final step for IRA account holders over the age 70 ½. The amount recharacterized will need to be added back into the year-end IRA account total to calculate the current year RMD. Roth IRAs are not subject to RMD rules. Retirees that do not need money from their IRA to support their lifestyle may consider converting their IRA to a Roth to avoid future RMDs. Those considering a conversion must remember that the amount of the current year RMD is not eligible for conversion to a Roth.

The first dollars taken from an IRA after you reach age 70 ½ are deemed by the IRS as going toward the RMD. Therefore, you must distribute the amount of the RMD before the rest of your IRA is converted to a Roth. Failure to do so could result in an excess contribution to a Roth IRA. The IRS levies a 6% penalty for each year this money remains in the Roth IRA.

Not sure whether to convert or not? Convert. You can always undo the conversion next year if you find out it was not a good idea. What other tax planning techniques give you such an easy reset button? Keep in mind you have to wait until the year following the conversion or more than 30 days after the recharacterization, whichever comes later before you can reconvert. Basically, you can only convert the same assets once in a year.

Rick’s Tips:

  • It’s a good time to consider a Roth conversion when IRA asset values have declined due to a market correction.
  • A Roth conversion is generally a good decision when the assets will be staying in the Roth growing tax free for a long time.
  • Taxpayers can “undo” a Roth conversion through recharacterization up until October 15th of the year following conversion.

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