Estate Planning Attorney With Hook Law Center Explains Roth IRAs, Conversions, and Recharacterizations
Virginia Beach, VA (Law Firm Newswire) November 18, 2013 – Workers may convert individual retirement accounts (IRAs) from traditional to Roth IRAs, but some who do so will later undo that conversion.
Roth IRAs present certain advantages and disadvantages versus traditional IRAs, and each year, many people elect to make the conversion to Roth. When current circumstances or expectations for the future change, as they so often do, that conversion may be undone in a process called “recharacterization.” Estate planning attorney Andrew Hook explains why people convert or recharacterize their accounts and the rules governing the processes.
“Contributions to traditional IRAs are tax-deductible,” Hook said. “Contributions and earnings are taxed when withdrawn, during retirement. Traditional IRAs work well for the many people who expect to pay lower tax rates in retirement than they do while employed.” Roth IRAs work differently and are better-suited for a different type of investor.
“Contributions to Roth accounts are made with after-tax dollars – contributions do not lower your tax liability,” Hook went on. “However, withdrawals of contributions and earnings in retirement are tax-free. Roth IRAs are popular among those who do not expect their income, and therefore tax rate, to drop significantly in the future.”
Accordingly, investors might choose to convert from traditional IRAs to Roth IRAs if their expected future tax liability increases with respect to their current tax liability.
“Conversions were very popular among high earners toward the end of 2012 because of the upcoming higher tax bracket for income over $400,000,” Hook said. “Earlier, conversions had seen a huge increase in popularity in 2010, when income limits preventing high earners from converting were lifted.”
Conversion incurs a tax liability, because the funds in a traditional IRA have not been taxed. Using the funds within an IRA to pay the cost of conversion is undesirable, because it counts as an early withdrawal, which incurs a penalty of 10 percent.
For those who convert to a Roth IRA only to later change their minds, a reversal of the conversion, or re-characterization, is allowed, if completed by October 15 of the following year. Another conversion after a re-characterization is permitted in the year after the first conversion, as long as 30 days have passed since the re-characterization.
“An example of someone who might wish to re-characterize their IRA after a conversion is an individual who got laid off or took a large pay cut,” Hook explained. “Their tax rate likely went down, so if they re-characterize, they can later redo the conversion at their new, lower tax rate. In the meantime, recovering the taxes they paid will increase their liquidity.”
Another situation where re-characterization is desirable is if the value of account holdings drops significantly following a conversion. By re-characterizing the account and converting the lesser amount later, investors can incur a lower tax bill.
Hook Law Center
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Virginia Beach, Virginia 23452-1294
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Suffolk VA 23435