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.

Back-Door Roth IRAs

Many individuals who are saving for retirement favor Roth IRAs over traditional IRAs because the former allows for both accumulation and post-retirement distributions to be tax-free. In comparison, contributions to traditional IRAs may be deductible, earnings are tax-deferred, and distributions are generally taxable. Anyone who is under age 70.5 and who has compensation can make a contribution to a traditional IRA (although the deduction may be limited). However, not everyone is allowed to make a Roth IRA contribution.

High-income taxpayers are limited in the annual amount they can contribute to a Roth IRA. The maximum contribution for 2016 is $5,500 ($6,500 if age 50 or older), but the allowable 2016 contribution for joint-filing taxpayers phases out at an adjustable gross income (AGI) between $184,000 and $194,000 (or an AGI between $0 and $9,999 for married taxpayers filing separately). For unmarried taxpayers, the phase-out is between $117,000 and $132,000.

However, tax law also includes a provision that allows taxpayers to convert their traditional IRA funds to Roth IRAs without any AGI restrictions. Although deductible contributions to a traditional IRA have AGI restrictions (for those who are in an employer’s plan), nondeductible contributions do not.

Thus, higher-income taxpayers can first make a nondeductible contribution to a traditional IRA and then convert that IRA to a Roth IRA. This is commonly referred to as a “back-door Roth IRA.”

BIG PITFALL: However, there is a big pitfall to back-door IRAs, and it can produce unexpected taxable income. Taxpayers and their investment advisers often overlook this pitfall, which revolves around the following rule: For distribution purposes, all of a taxpayer’s IRAs (except Roth IRAs) are considered to be one account, so distributions are considered to be taken pro rata from both the deductible and nondeductible portions of the IRA. The prorated amount of the deducted contributions is taxable. Thus, a taxpayer who is contemplating a back-door Roth IRA contribution must carefully consider and plan for the consequences of this “one IRA” rule before making the conversion.

There is a possible, although complicated, solution to this problem. Rolling over IRAs into other types of qualified retirement plans, such as employer retirement plans and 401(k) plans, is permitted tax-free. However, a rollover to a qualified plan is limited to the taxable portion of the IRA. If an employer’s plan permits, a taxpayer could roll the entire taxable portion of his or her IRA into the employer’s plan, leaving behind only nondeductible IRA contributions, which can then be converted into a Roth IRA tax-free.

Before taking any action, please call this office to discuss strategies for making Roth IRA contributions or to convert existing traditional IRAs into Roth IRAs.

Traditional to Roth IRA Conversions – Should you? Did you? Wish you Hadn’t?

The tax provision that allows taxpayers to convert a Traditional IRA to a Roth IRA is a great tax-planning tool when used properly, and timing is everything.

To make a conversion, you must pay income taxes on the amount of the traditional IRA converted to a Roth IRA. So why would one want to do that? Well, the answer is that Roth IRAs enjoy tax-free accumulation and distributions, whereas the earnings in and contributions made to a traditional IRA are fully taxable whenever they are withdrawn. (An exception is if the contributions to the traditional IRA were treated as non-deductible. In that case, each distribution is nontaxable or partly nontaxable if only some of the contributions had not been deducted.)

So, you might consider converting during a year in which your income is abnormally low or a year in which your income might even be negative due to abnormal deductions or business losses. Under such cases, you might even be able to make a conversion tax-free. Keep in mind that you do not have to convert the entire amount in the traditional IRA; rather, you can choose any amount you wish to convert to fit your circumstances, and with proper tax planning, you can substantially minimize the conversion tax and the tax on your future retirement benefits.

You might also consider a conversion at a time when the IRA value is low due to a decline in the stock market, like the dip in stock values that occurred in September this year when the Dow index dropped from the low 18,000s to close to 16,000.

Those examples demonstrate when timing might be right for a conversion. On the flip side, if you converted earlier in the year, you could end up paying taxes on an amount that has declined in value due to the market downturn and wish you hadn’t converted. Well, the good news is that you can undo a conversion.

A taxpayer who converts a traditional IRA to a Roth IRA during 2015 can back out of the conversion by recharacterizing the Roth IRA as a traditional IRA any time up to the extended due date of the 2015 return. This involves transferring the converted amount (plus earnings or minus losses) from the Roth IRA back to a traditional IRA via a direct (trustee-to-trustee) transfer.

IRA Conversion Issues

Everyone’s financial circumstances are unique and other issues to consider are:

  • Are there enough years before retirement to recoup the conversion tax dollars through tax-free accumulation?
  • Will you be in a lower or higher tax bracket in the future?
  • Where would the money to pay the conversion tax come from? Generally, it must be from separate funds. If it is taken from the IRA being converted, for individuals under age 59½, the funds withdrawn to pay the tax will also be subject to the 10% early-distribution penalty in addition to being taxed.
  • It might be appropriate for you to design your own custom conversion plan over a number of years rather than converting everything at once.

Conversions can be tricky! If you are considering a conversion, it might be appropriate to call 212-697-8540 for an appointment so that we can help you properly analyze your conversion options.

Retirement Savings: the Earlier, the Better

Generally, teenagers and young adults do not consider the long-term benefits of retirement savings. Their priorities for their earnings are more for today than that distant and rarely considered retirement. Yet contributions to a retirement plan early in life can enjoy years of growth and provide a substantial nest egg at retirement.

Due to its long-term benefits of tax-free accumulation, a nondeductible Roth IRA may be the best option. During most individuals’ early working years, their income is usually at its lowest, allowing them to qualify for a Roth IRA at a time where the need for a tax deduction offered by other retirement plans is not important.

Because retirement will not be their focus at that age, young adults may balk at having to give up their earnings. Parents, grandparents, or other individuals might consider funding all or part of the child’s Roth contribution. It could even be in the form of a birthday or holiday gift. Take, for example, a 17-year-old who has a summer job and earns $1,500. Although the child is not likely to make the contribution from his or her earnings, a parent could contribute any amount up to $1,500 to a Roth IRA for the child.*

But keep in mind that young adults, like anyone else, must have earned income to establish a Roth IRA. Generally, earned income is income received from working, not through an investment vehicle. It can include income from full-time employment, income from a part-time job while attending school, summer employment, or even babysitting or yard work. The amount that can be contributed annually to an IRA is limited to the lesser of earned income or the current maximum of $5,500.

Parents or other individuals who contribute the funds need to keep in mind that once the funds are in the child’s IRA account, the funds belong to the child. The child will be free to withdraw part or all of the funds at any time. If the child withdraws funds from the Roth IRA, the child will be liable for any early withdrawal tax liability.

Consider what the value of a Roth IRA at age 65 would be for a 17-year-old who has funds contributed to his or her IRA every year through age 26 (a period of 10 years). The table below shows what the value will be at age 65 at various investment rates of return.


Value of a Roth IRA—Annual Contributions of $1,000
for 10 years beginning at age 17
Investment Rate of Return
Value at Age 65


What may seem insignificant now can mean a lot at retirement. Individuals who are financially able to do so should consider making a gift that will last a lifetime. It could mean a comfortable retirement for your child, grandchild, favorite niece or nephew, or even an unrelated person who deserves the kind gesture.

*Amounts contributed to an IRA on behalf of another person are nondeductible gifts by the donor and are counted toward the donor’s annual $14,000 (2014 and 2015 gift exclusion per done).

If you would like more information about Roth IRAs or gifting contributions to a Roth on behalf of someone else, please contact this office.

Beware of the One-per-12-Month IRA Rollover Limitation Beginning in 2015

The tax code allows an individual to take a distribution from his or her IRA account and avoid the tax and early distribution penalties if the distribution is redeposited to an IRA account owned by the taxpayer within 60 days of receiving the distribution.

Early in 2014, in a tax court case, the court ruled that taxpayers could only have one IRA rollover per 12-month period. This was contrary to the IRS’s long-standing one rollover per every IRA account every 12 months. This far more liberal position was also included in published IRS guidance. However, contrary to general public opinion, guidance provided by the IRS in their publications is not citable, carries no weight in audit or court, and only represents the IRS’ interpretation of tax law.

As a result, the IRS has adopted the Court’s more restrictive position, but will not apply the new interpretation until 2015, giving taxpayers time to become aware of the new restrictions. The IRS is modifying its published 2015 guidance to reflect this new position.

The IRS announced in November that the one-per-12-month-period rollover rule also applies to Simplified Employer Pension Plans (SEPs) and SIMPLE plans. Included in the November announcement, the IRS indicated it would not count a distribution taken in 2014 and rolled over in 2015 (within the 60-day limit) as a 2015 rollover.

Not counted towards the one-per-12-month rule are traditional to Roth IRA conversions or trustee-to-trustee IRA transfers where the funds are directly transferred from one IRA trustee to another.

Please call this office if you are planning an IRA distribution and subsequent rollover and are not positive it falls within the one-per-12-month limit.