Tax Reform Didn’t Kill All Roth Recharacterizations

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.

Conclusion

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.

• Check out previous coverage of planning with Roth IRAs in Advisor’s Journal.
• For in-depth analysis of the Roth IRA rules,  see Advisor’s Main Library.
• Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.