Although many advisors may be tempted to gloss over the potential for recharacterization transactions post-tax reform, the recharacterization rules can still provide a valuable tool for many clients who wish to transfer funds between IRAs.
Prior to last year’s tax reform, a client who converted a traditional IRA to a Roth account had the ability to change his or her mind and “undo” the transaction by October 15 of the following year. This essentially gave the client a period of time to evaluate the transaction and determine whether it made sense in hindsight. While this did provide an effective tool for clients considering Roth conversions, it is not the only place where recharacterizations could add value for clients—and advisors need to be aware of the situations where the recharacterization rules are still alive and kicking to help clients avoid penalties post-reform.
The New Recharacterization Rules
The 2017 Tax Act eliminated a client’s ability to recharacterize a conversion from a traditional, SEP or SIMPLE IRA to a Roth IRA after December 31, 2017. However, clients who executed Roth conversions for the 2017 tax year still have until October 15, 2018 to recharacterize the transaction under the previously existing rules.
Further, the new law continues to permit recharacterization of transactions that were not valid Roth conversions to begin with—meaning that the recharacterization rules essentially continue to apply for any transaction that was not originally a rollover of traditional retirement funds into a Roth.
Therefore, the recharacterization rules can still be used for clients who need to correct an error in their IRA contributions or that occurred when moving funds between accounts. Errors in IRA contributions or rollovers can occur for a variety of reasons and, absent proper correction, can subject a client to steep penalties (or the entire amount involved being treated as a taxable distribution in a single year).
Recharacterizing a Roth IRA is still appropriate under the new tax reform law in order to correct an error in the original contribution. For example, if a client contributes to a Roth IRA and later discovers that his or her income exceeded the annual income thresholds (so that the client was actually ineligible to make the Roth contribution), he or she can recharacterize the transaction as a contribution to a traditional IRA in order to avoid the six percent excess contribution penalty that would otherwise apply to the improper Roth contribution.
The recharacterization rules can also be used to correct a contribution of funds into the wrong IRA—whether through institutional error or because a lack of knowledge of the contribution rules. If a client holds funds in an employer-sponsored Roth 401(k), for example, he or she may wish to roll those funds into an independent IRA.
However, it is only permissible to roll those funds into a Roth IRA, and if they are mistakenly transferred to a traditional IRA, the entire transaction will be treated as a distribution and the excess contribution rules discussed above will also come into play.
In this situation, the client can use the recharacterization rules to fix the invalid rollover—transferring both the rolled over amount and any earnings on their value into the correct Roth IRA.
These recharacterizations remain permissible under the new tax reform law, and are essentially accomplished by trustee-to-trustee transfer at the relevant financial institutions. The deadline for a permissible recharacterization also remains the same under the new tax law—October 15.
Tax reform did eliminate a valuable strategy by limiting the recharacterization rules to transfers other than typical Roth conversions—but advisors must remain aware of the situations in which recharacterizations can continue to be used to avoid penalties and add value for clients even post-reform.