Tax Reform Cracks Down on IRA Recharacterizations

Note: This is one of a series of articles explaining how the various tax changes in the GOP’s Tax Cuts & Jobs Act (referred to as “the Act” in this article), which passed in late December of 2017, could affect you and your family, both in 2018 and future years. This series offers strategies that you can employ to reduce your tax liability under the new law.

If you have been or are anticipating converting your traditional IRA to a Roth IRA, you should be aware of a tax trap that Congress built into the Act.

Background: There are two types of IRA accounts:

  • Traditional IRA – Is a retirement plan that generally provides a taxpayer with a tax deduction when a contribution is made to the account. Then when distributions are taken from the account they are fully taxable, including earnings.
  • Roth IRA – Is also a retirement plan, but unlike the traditional IRA, a Roth IRA does not provide a tax deduction for the contribution. Thus, once a taxpayer reaches retirement age, all of the distributions are totally tax-free.

The big benefit here is that all the Roth account earnings over the years end up being tax-free as opposed to those from the traditional IRA, which are taxable. For that reason, many taxpayers take advantage of a provision in the law that allows them to convert a traditional IRA to a Roth IRA. However, for the year that a traditional IRA is converted to a Roth IRA, the converted amounts are taxable. Therefore, most IRA owners carefully plan the amount and timing of the conversions to be done in a year when they are in lower-than-normal tax brackets.

Prior law included a provision that allowed taxpayers to change their minds and undo a conversion by recharacterizing the Roth converted amounts back to traditional IRAs and thus also undoing the tax liability. This was helpful for those who had underestimated the tax liability, did not have money available to pay the tax, saw the value of the converted IRA drop (which would mean they’d be paying tax on a phantom value) or just changed their mind.

Unfortunately, the Act pulled the plug on recharacterizations, and beginning in 2018, taxpayers can no longer undo a conversion. Once a conversion is made, the IRA owner will have to live with the tax consequences. This rule applies for conversions from a traditional IRA, SEP or SIMPLE to a Roth IRA. The new law also prohibits recharacterizing amounts rolled over to a Roth IRA from other retirement plans, such as 401(k) or 403(b) plans.

However, for taxpayers who made a conversion to a Roth IRA in 2017, the IRS has announced the conversion may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by October 15, 2018. A Roth IRA conversion made on or after January 1, 2018, cannot be recharacterized.

Recharacterization is still permitted with respect to other contributions. For example, an individual may make a contribution to a Roth IRA for a particular year and, before the due date for their income tax return for that year, recharacterize it as a contribution to a traditional IRA or vice versa.

If you have questions related to converting a traditional IRA to a Roth IRA, please give this office a call. If you would like to strategize on how to minimize the tax on a conversion, please contact us.

Important Facts to Know About IRAs

The individual retirement account (IRA) is one of the favored ways to save money for retirement. There are two types of IRAs: the traditional IRA and the Roth IRA. The annual maximum that an individual can be contributing between the two types of IRAs is $5,500, unless the individual is 50 years of age or older, and then the maximum is increased to $6,500. The basic contribution amount is inflation adjusted annually and the amount quoted is for 2017, while the additional amount for those 50 and older is fixed at $1,000. Contributions to an IRA may or may not be tax deductible depending on the type of IRA and, in some cases, the amount of the taxpayer’s income for the contribution year and whether the taxpayer participates in an employer’s retirement plan.

Compensation – In order to contribute to either type of IRA, the taxpayer must have compensation equal to the amount of the contribution. Compensation includes wages, tips, bonuses, professional fees, commissions and net income from self-employment. Alimony recipients may treat alimony as compensation for purposes of making IRA contributions. Also, members of the military receiving excludable combat pay may count the excluded amount as compensation for IRA purposes.

Active Participation in Another Retirement Plan – When an individual is an active participant in another retirement plan, such as an employer qualified pension, profit sharing or stock bonus plan, a qualified annuity, tax-sheltered annuity, government plan or simplified employee pension plan (SEP), the deductible IRA contribution is phased out for higher-income taxpayers. For 2017, the adjusted gross income (AGI) phaseout ranges are illustrated below.

Filing Status
Single and
Head of Household
Married Joint and
Surviving Spouse
Married Filing Separate
Phaseout Range
$62,000 to $72,000
$99,000 to $119,000
$0 to $10,000

There is a special rule for those who are married and filing jointly when one spouse is not an active participant in another retirement plan. That spouse’s phase-out range is increased to AGIs between $186,000 and $196,000.

Example: Sally, age 45 and single, is employed and her only income for 2017 is W-2 wages in the amount of $67,000. She is also an active participant in her employer’s 401(k) plan. She has no adjustments to her income, so her AGI for the year is also $67,000. Since she participates in her employer’s pension plan her IRA contribution is subject to the phaseout limitations. Her AGI is halfway through the phaseout range, so her deductible IRA contribution is limited to $2,750 (1/2 of $5,500). If Sally’s AGI had been $72,000 or more, she would not be able to make a deductible IRA contribution.

These phaseout limitations only apply to the deductible amount of a traditional IRA contribution. An individual can still contribute the full amount, limited by his or her compensation, but the excess amount is treated as a nondeductible contribution to the traditional IRA and establishes a basis. Then in the future, when an IRA distribution is taken, a prorated amount of the distribution will be nontaxable.

Nondeductible Contributions – In addition to making nondeductible contributions that are ineligible for IRA deductions due to active participation and income limits, an individual can also elect to treat otherwise deductible contributions as nondeductible. However, before making nondeductible IRA contributions, an individual should first consider a Roth IRA, discussed below, as an alternative.

Spousal IRA – An often-overlooked opportunity for maximizing IRA contributions is what is referred to as a “spousal IRA.” This allows a spouse with no or very little earned income to contribute to his or her IRA as long as the other spouse has sufficient earned income to cover them both.

Example: Tony is employed and his W-2 for 2017 is $100,000. His wife, Rosa, age 45, has a small income from a part-time job totaling $900. Since her own compensation is less than the contribution limits for the year, she can base her contribution on their combined compensation of $100,900. Thus, Rosa can contribute up to $5,500 to an IRA for 2017. Without this special rule, Rosa’s contribution would be limited to $900, the amount of her own compensation.

Roth IRA – An alternative to a traditional IRA is the Roth IRA. Whereas traditional IRAs provide a tax-deductible contribution and tax-deferred accumulation, Roth IRAs provide no tax deduction but have tax-free accumulation. Thus, when retirement distributions are taken from a Roth IRA, they are tax-free. On the other hand, those taken from a traditional IRA are fully taxable except for the non-deductible contributions discussed above.

However, contributions to Roth IRAs are never tax-deductible and the allowable contribution is phased out for higher income taxpayers, regardless of whether they actively participate in an employer’s retirement plan. For 2017, the adjusted gross income (AGI) phaseout ranges for Roth IRA contributions are illustrated below.

Filing Status
Single and
Head of Household
Married Joint
Married Filing Separate
Phaseout Range
$118,000 to $133,000
$186,000 to $196,000
$0 to $10,000

Example: Rosa, in the previous example, can designate her IRA contribution to be either a deductible traditional IRA or a nondeductible Roth IRA because the couple’s AGI is under $186,000. Had the couple’s AGI been $191,000, Rosa’s allowable contribution to a deductible traditional or Roth IRA would have been limited to $2,750 because of the phaseout. The other $2,750 could have been contributed to a nondeductible traditional IRA.

Back-Door Roth IRAs – Those individuals whose incomes are too high to qualify for a Roth IRA contribution can make a traditional IRA contribution and then convert the contribution to a Roth IRA using an IRA conversion process, discussed later in this article, available to all taxpayers of any income level.

Contribution Timing – Because income (AGI) limitations apply to IRAs, contributions can be made after the close of the year, giving taxpayers time to accurately determine their AGIs for the year and the correct amount of their IRA contributions. The contribution must be made no later than the unextended due date for filing a return, which is April 15. However, if the due date falls on a weekend or holiday, the due date is extended to the next business day. So, 2017 contributions must be made by April 17, 2018.

Penalties – There is a 6% penalty on amounts contributed to an IRA in excess of the allowable contribution amount. This penalty continues to apply annually until the excess is corrected. There is also a 10% early distribution penalty on the taxable amount withdrawn from an IRA before reaching age 59½. However, some or all of the 10% penalty is waived under certain circumstances, such as for first-time homebuyers, to pay for higher education expenses, to pay for medical insurance by some unemployed individuals or when a taxpayer becomes disabled. For those wishing to retire early, the penalty can also be waived if distributions are a series of substantially equal payments over the taxpayer’s life and continue until the taxpayer reaches age 59½ or for a minimum of five years, whichever is later.

Rollovers – From time to time a taxpayer may need to take funds from the IRA. If they are returned within 60 days, the distribution is not taxable and the 10% early withdrawal penalty will not apply. However, this is only allowed once in any 12-month period. This restriction does not apply to direct trustee-to-trustee transfers when the IRA owner is switching trustees or investments. CAUTION: All IRA accounts are considered one, so this rule applies collectively to all IRA accounts, meaning that an individual cannot make an IRA-to-IRA rollover if he or she has made such a rollover involving any of his or her IRAs in the preceding 12-month period.

Conversions – To take advantage of the tax-free benefits of a Roth IRA, an IRA owner can convert a traditional IRA to a Roth IRA any time, but taxes must be paid on the amount of the taxable traditional IRA funds converted to a Roth IRA. Timing is key when making a conversion, because one would want to do that in a low-income year or make a series of conversions so as to spread the income over a number of years. If contemplating a conversion, it should be accomplished as early in life as possible to provide a longer period of tax-free accumulation.

If an IRA conversion is made and then the IRA owner later regrets making the conversion, the Roth IRA can be recharacterized as a traditional IRA up to the extended due date of the return, which for a 2017 return would be October 15, 2018. Typical reasons for recharacterizing include not being able to pay the tax on the conversion or if the IRA has dropped in value after the conversion. Starting in 2018, this will no longer be permitted.

Retirement Distributions – For both traditional and Roth IRAs, distributions can begin once a taxpayer reaches age 59½ without penalty. For traditional IRA owners, once they reach age 70½ they must begin taking what is referred to as a minimum required distribution (RMD) each year. The minimum amount is based upon current age and the value of the IRA account. Roth IRAs are not subject to the RMD requirement. Failing to take a distribution of the required minimum amount may result in a 50% penalty of the amount that should have been withdrawn but wasn’t. However, the IRS will waive the penalty under certain conditions. TIP: In any post-retirement year when your income is below the taxable threshold, you have an opportunity to withdraw from the IRA tax-free. You should consider doing so even if you don’t need the income. You can put it away in a savings account until you do need it.

As you can see, the rules regarding IRAs are complex, and this article has only covered the most commonly encountered ones. Please give us a call if you would like to discuss how IRAs would apply to your particular circumstances or if you are in need of assistance planning for your retirement.

Naming Your IRA Beneficiary – More Complicated Than You Might Expect

The decision concerning whom you wish to designate as the beneficiary of your traditional IRA is critically important. This decision affects:

  • The minimum amounts you must withdraw from the IRA when you reach age 70 ½;
  • Who will get what remains in the account after your death; and
  • How that IRA balance can be paid out to beneficiaries.

What’s more, a periodic review of whom you’ve named as IRA beneficiaries is vital to ensure that your overall estate planning objectives will be achieved in light of changes in the performance of your IRAs and in your personal, financial, and family situation. For example, if your spouse was named as your beneficiary when you first opened the account several years ago and you’ve subsequently divorced, your ex-spouse will remain the beneficiary of your IRA unless you notify your IRA custodian to change the beneficiary designation.

The issue of naming a trust as the beneficiary of an IRA comes up regularly. There is no tax advantage to naming a trust as the IRA beneficiary. Of course, there may be a non-tax-related reason, such as controlling a beneficiary’s access to money; thus, naming a trust rather than an individual(s) as the beneficiary of an IRA could achieve that goal. However, that is not typically the case. Naming a trust as the beneficiary of an IRA eliminates the ability for multiple beneficiaries to maximize the opportunity to stretch the required minimum distributions (RMDs) over their individual life expectancies.

Generally, trusts are drafted so that IRA RMDs will pass through the trust directly to the individual trust beneficiary and, therefore, be taxed at the beneficiary’s income tax rate. However, if the trust does not permit distribution to the beneficiary, then the RMDs will be taxed at the trust level, which has a tax rate of 39.6% on any taxable income in excess of $12,500 (2017 rate). This high tax rate applies at a much lower income level than for individuals.

Distributions from traditional IRAs are always taxable whether they are paid to you or, upon your death, paid to your beneficiaries. Once you reach age 70 ½, you are required to begin taking distributions from your IRA. If your spouse is your beneficiary, he or she can delay distributions until he or she reaches age 70 ½ if your spouse is under the age of 70 ½ upon the inheritance of your IRA. The rules are tougher for non-spousal beneficiaries, who generally must begin taking distributions based upon a complicated set of rules.

Since IRA distributions are taxable to beneficiaries, beneficiaries usually wish to spread the taxation over a number of years. However, the tax code limits the number of years based on whether the decedent has begun his or her age 70 ½ RMDs at the time of his or her death.

To ensure that your IRA will pass to your chosen beneficiary or beneficiaries, be certain that the beneficiary form on file with the custodian of your IRA reflects your current wishes. These forms allow you to designate both primary and alternate individual beneficiaries. If there is no beneficiary form on file, the custodian’s default policy will dictate whether the IRA will go first to a living person or to your estate.

This is a simplified overview of the issues related to naming a beneficiary and the impact on post-death distributions. Uncle Sam wants the tax paid on the distributions, and the rules pertaining to how and when beneficiaries must take taxable distributions are very complicated.

It should also be noted that some members of Congress have expressed their displeasure with stretch-out IRAs that have permitted some beneficiaries to extend for decades the payout period from the IRAs they inherited. These legislators would prefer that total distribution from inherited IRAs be made within five years after the IRA owner’s death. So it is possible that we will see tax law changes in this area.

It may be appropriate to consult with this office regarding your particular circumstances before naming beneficiaries.

Want To Make An IRA Contribution For 2016? You Still Have Time

If you wish to make an IRA contribution for 2016, you still have time. Contributions can be made up to the unextended due date of your tax return, which for 2016 is April 18, 2017.

There are several benefits to making an IRA contribution, the most important one being that you are putting money aside for your future retirement. The following is a rundown of the rules and tax tips relating to making IRA contributions and the potential tax benefits.

Age Rules – You must be under age 70 ½ at the end of the tax year to contribute to a traditional IRA. There is no age limit to contribute to a Roth IRA.

Compensation Rules – You must have taxable compensation to contribute to an IRA. This includes income from wages and salaries and net self-employment income. It also includes tips, commissions, bonuses and alimony. If you are married and file a joint tax return, only one spouse needs to have compensation in most cases.

When to Contribute – You can contribute to an IRA at any time during the year. For the contribution to count for 2016, you must contribute by the due date of your tax return. This does not include extensions. This means most people must contribute by April 18, 2017. If you contribute between January 1 and April 18 of 2017 for 2016, make sure your plan sponsor designates it as a 2016 contribution.

Contribution Limits – In general, the most you can contribute to your IRA for 2016 is the smaller of either your taxable compensation for the year or $5,500. If you were age 50 or older at the end of 2016, the maximum you can contribute increases to $6,500. If you contribute more than these limits, an additional tax will apply. The additional tax is six percent of the excess amount contributed that is in your account at the end of the year.

Deductibility – Contributions to a Traditional IRA are generally tax deductible, but the deductible amount phases out for taxpayers who are active participants in their employer’s retirement plan. (Box 13 on your W-2 form from your employer will be checked if you are an active participant in your employer’s plan.) A higher phaseout threshold applies to unemployed spouses who make contributions based on the other spouse’s income. For 2016, the adjusted gross income (AGI) phaseout range is:

Filing Status Phaseout Threshold Fully Phased Out
Unmarried
$61,000
$71,000
Married Filing Jointly
$98,000
$118,000
Married Filing Separately
$0
$10,000
Spousal IRA
$184,000
$194,000

If you can deduct the Traditional IRA contribution, it will lower your AGI, taxable income and tax liability. The amount of your AGI is used to limit certain other deductions and tax credits. So deductible IRA contributions are a way to reduce your AGI and potentially increase other deductions and credits. For example, if you are obtaining your health insurance from a Government Marketplace, lowering your AGI could actually increase the amount of your premium tax credit that helps to pay for your insurance.

Saver’s Credit – For lower income taxpayers, there is a tax credit that helps you pay for your IRA contribution. The credit is a percentage of your IRA contribution ranging from 50% to 10% of your first $2,000 of IRA contributions. If you are married, it applies to each spouse individually. For 2016, the credit applies to married taxpayers with an AGI less than $61,500, single taxpayers under $30,750 and head of household filers under $46,125.

Choosing Between Traditional & Roth IRAs – Generally distributions (except for non-deductible contributions) from Traditional IRAs are taxable, while distributions from Roth IRAs are tax-free.

For more details on how an IRA contribution will impact your 2016 tax return, please give this office a call. We can also determine the effect at your tax appointment.