For those of you who converted your traditional IRA to a Roth IRA in 2015 and are watching the market value of that IRA fall, there is relief available to you. You can reverse your previously made conversion. This is called an IRA recharacterization and is one of the few “tax loopholes” available to all taxpayers where you almost always come out ahead.
Let’s say that you converted $50,000 from a traditional IRA to a Roth IRA in 2015. If your effective tax rate is 25%, that means that you will incur an additional 2015 income tax liability of $12,500. Let’s assume that the Roth IRA has declined in value by $20,000 and is now worth $30,000. Your “effective tax rate” on this conversion is 41.7% ($12,500/$30,000).
The good news is that the tax law allows you a Mulligan and you can undo what you did. The Mulligan is that the tax law allows you to recharacterize (reverse) your Roth conversion as if it never happened. What is the deadline for making this recharacterization? It needs to be completed by the last date, including extensions, for filing your 2015 tax return, which would be either April 15, 2016 or October 17, 2016 (if Form 4868 is timely filed requesting an extension of time to file). Thus you have the balance of 2015 and 9 ½ months in 2016 to make the recharacterization.
Another great aspect of this “tax loophole” is that you can convert those recharacterized IRA funds a second time to a Roth IRA. The amount which is recharacterized includes any losses and earnings. If you recharacterize a conversion, you cannot re-convert the same money in the year of the original conversion, nor within 30 days after the recharacterization. Thus, depending upon your view as to which direction the markets are heading, you may wish to recharacterize your Roth conversion when the market is at what you perceive to be near its low. You then wait 30 days and do the Roth conversion again in 2016 hoping that the market will increase. If the account monies you are working with are worth $30,000 when you convert a second time, the additional taxes you would pay would be $7,500 (25% of $30,000). You have just reduced your 2015 tax bill by $5,000 ($12,500 on the initial conversion less $7,500 on the second conversion). If you think that the market will continue to drop, you do not have to make the second conversion and the recharacterization will have saved you $12,500 in 2015 taxes paid.
There are some considerations you should discuss with your financial advisor and your tax professional. What is the ideal amount to recharacterize so that the amount converted does not push you into a higher tax bracket? If you already have Roth accounts before the conversion, consider using a separate Roth account for making your conversion. That way if you have to do a re-do (recharacterization), the earnings on the monies converted are easy to identify. Once the conversion is finalized, you can then consolidate your Roth accounts. If you are planning to do a recharacterization, you may wish to delay the filing of your 2015 tax return until the recharacterization occurs because that 2016 event is included in your 2015 tax return.
If you want to discuss your tax planning and tax preparation concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
