IRA Recharacterizations: What You Can and Can't Do Now

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As part of the recently enacted tax laws, investors converting traditional IRA assets to Roth lost a valuable escape hatch. Joining me via Skype to discuss the demise of recharacterizations is financial planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: My pleasure. Happy to join.

Benz: Prior to these laws being finalized, we had heard a lot of hand-wringing about major changes to the retirement savings system. A lot of those ideas did not come to fruition in the final tax laws, but one thing that did come through is the banning of what's called recharacterization of an IRA. Let's talk about what that is, why people were using it, and what's next for recharacterization.

Kitces: It was interesting watching the tax legislation evolve, but early on as you said, there was a lot of discussion about major changes and overhauls. What we really ended up with was more of the so-called loophole closers and the crackdowns. This definitely falls in that category. The idea of a recharacterization is when money goes into a Roth account and you realize later, oops, maybe I didn't mean to do that or I couldn't have done that, it was essentially the undo button to put it back. It could apply in two situations, either number one: I just contributed to a Roth and now I want to change my mind and do it the traditional instead; or I converted from an IRA to a Roth and now I'd like to hit the undo button and switch it back to the original account instead. It sounds sort of straightforward to say, of course if you do it, you should be able to undo it, but we have pretty specific rules around what happens when money leaves IRAs with taxes and penalties. We needed a formal rule that says if you just put money into a Roth, here's how you can literally recharacterize it over to the other type of pretax traditional IRA accounts. The recharacterization rules were the formal recognition of the ability to do that.

Benz: Just to clarify, in terms of the inadvertent, incorrect contribution, maybe I meant to contribute to a Roth IRA and I did a traditional IRA instead, it sounds like I'll still be able to undo mistakes like that at the contribution level. It's the conversion thing that's changing?

Kitces: Correct. We have this rule framework that let you do the undo process. There are two primary scenarios. Either I contributed to one and I say, oops, I meant to contribute to the other; or I converted from an IRA to a Roth and I say, oops, maybe I didn't want to do that, and I want to go back. The origin of this rule was actually just because the original Roth accounts, when they were first established in 1997, all had income limitations. There was an income limit to contribute, there was an income limit to convert. One of the primary risks was, you would put the money in a Roth and then you would find out when you're preparing your taxes that you were over the income limit, and you weren't supposed to have done that. You could put it back.

Now what changes, in 2010 we eliminated the income limits on Roth conversions. There's no such thing as a conversion that you did and would need to undo because of income limits. The only time you would undo it is if you wanted to or changed your mind, which was not really the purpose of the rules. The problem that had occurred is not only is it no longer necessary to recharacterize just because we changed our minds, but people actually began to use this as a proactive strategy where they would say, I'll do a conversion and then if the market goes up then I'll hold on to it, but if the market goes down, then I'll recharacterizate it, and I'll just do it over again at the new lowered dollar amounts, and it was kind of, you get to run a horse race and then pick the winner after the race ends. it was viewed as a form of abuse. To crack down on that specific version, Congress came in and said recharacterizations of conversions are no longer allowed. The only real reason for it was income limits. Income limits are gone. In theory, we don't need recharacterizations anymore.

They are just removed from the conversion part, but they stay for the contribution part, because we still have income limits for the contribution part. You might actually accidentally contribute when you couldn't, and you need a way to move it. Re

Benz: Just to review, when you do a conversion, say from traditional IRA to Roth, let's talk about the tax implications of that.

Kitces: When we do a conversion from traditional IRA to Roth, the whole point of this structure is it's taxable immediately, no early withdrawal penalties, and you now have a Roth account, the same way you would have had if you just contributed aftertax money to it in the first place. It's that opportunity to switch from pretax to tax-free. You pay taxes on the income when you convert it, but everything that grows from that point forward is tax free.

Benz: With no more do-overs on the horizon, if you do do the conversion and decide eh, in hindsight I wouldn't have done that, you're not going to be able to undo it. What are the implications for people who have significant traditional IRA assets, they're looking at them thinking, I'd like to get some of that over into the Roth column. Does that mean that doing a series of conversions versus giant lump sum conversions is a good strategy? What else would you recommend?

Kitces: What is important to recognize is that conversions are still on the table and we've seen some discussion about, well, does that mean I just can't convert anymore?No, no, we can still convert. It just means, as you said, there's no undo button, so, be careful about essentially doing it and regretting it. The biggest change for us that we're looking at so far is, in a world of recharacterization where I could do the conversion, see if things went up, keep them if they're up, recharacterize if they're down, we generally wanted to convert as early in the year as possible, 'cause if you're going to get a free look, you may as well take the longest free look period you can.

Now that recharacterizations aren't an option anymore and the conversion is essentially final and a done deal as soon as you do it, we're now shifting and looking at doing all of our conversions as late in the year as possible. In December, when we know almost all the income for a year, almost all the deductions for the year, if you've got other investments, you can get things like estimates of capital gains distributions. We know exactly what the income situation is before we actually do the conversion, because if we accidentally convert too much and drive up into a higher tax bracket, there's no undo button anymore. We're looking at these as late in the year as possible. You probably don't want to literally do it on Dec. 30, because if there's a paperwork snafu, you might not get it done in time. We're looking at Roth conversions going forward almost always going to be happening now in December, just so we have the clearest possible picture of everything else that's happening in the year, and is going to be on someone's tax return before we take the step of converting.

Benz: That's a great point. How does market action figure into your thinking here, if at all? If for example, stocks have some catastrophic drop of 25%, 30% or more, something like that, would that prompt you to start thinking about conversions for a portion of your client's assets?

Kitces: We view the primary driver of conversions simply based on what tax rates and what the tax planning opportunities are. My tax rates are lower now and they're expected to be higher in the future, then I want to do the conversion. If they're going to be higher now or lower in the future, hold on to my good, old-fashioned pretax IRA, take the money out later. That's really true regardless of market volatility. If the market has crashed, yeah, in theory, my Roth is cheaper in dollars to convert. But, if my tax rates are high now, low later, I'll still pay less in taxes later by just waiting and letting the rebound happen, and doing the conversion down the road and paying my taxes on the pro-rata growth along the way. In a world where we could recharacterize, we often wanted to convert early specifically so we had a chance to see, well, that market's up, we'll keep it. If the market's down, we'll recharacterize and just do it over again.

But now that we've lost that opportunity, for us, it just becomes even more of a focus of, we want to make sure that we get the tax brackets right. We want to make sure that we don't overconvert in the higher tax brackets now when we could have just waited and gotten the money out cheaper in the future. We're finding this is even more of a focus on looking at current tax brackets and how our income situation might change down the road.

Benz: OK, Michael. You're always such a great source of information for us. Thank you so much for being here today.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.