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ON THE MONEY: Strategies for managing a Roth IRA

August 26, 2018

So you decided to convert some of your hard-earned monies from your traditional IRA to a Roth IRA in 2017 but got cold feet due to the fact that you had underestimated the taxes that would be due on the transfer. You are allowed to cancel the conversion to a Roth IRA by means of a re-characterization. The usual method is to inform the trustee of the financial institution holding your Roth IRA to transfer the contribution plus earnings to a traditional IRA. That traditional IRA could be with the same trustee or, if the traditional IRA is with another financial institution, you would initiate a trustee-to-trustee direct transfer.

You are allowed to treat the contribution as having been made to a traditional IRA contribution by completing the “re-transfer” by Oct. 15, 2018, effectively ignoring the Roth IRA contribution. The earnings on the transferred amount would be taxable in 2018.

Sadly, there re-characterizations are not be available for tax years after 2017.

If you had rolled over funds from your employer-sponsored plan to a Roth IRA, then you may not simply move the “converted” monies back to the company plan, but instead, you must instruct the Roth trustee to transfer them to a new or existing traditional IRA.

If you reported as income the amount of the conversion on your 2017 return, you can file an amended tax return using form 1040X and essentially subtract from your taxable income the amount of the conversion or rollover. You have three years, including extensions, after the date that you filed your original return to submit this amended return, or if later, within two years after the date that you paid the tax.

A so-called “back door” Roth conversion is still available under the new tax law and works best if you have never contributed to a traditional IRA. Let’s say that you and your wife’s current adjusted gross income will be more than the Roth contribution maximum this year of $199,000. As a result, you cannot make a Roth contribution in 2018. However, you are allowed to contribute to a non-deductible IRA in 2018 and then convert that non-deductible IRA to a Roth IRA without any tax implications.

The rub comes in if you have made both pre-tax and post-tax contributions to a traditional IRA. In that case, a pro-rata rule applies. The taxes that you will owe on the conversion will depend on the ratio of IRA assets that have been taxed to those that have not. If the old, never-been-taxed IRA assets dwarf the new IRA consisting of already-been-taxed assets, most of the new IRA assets will be taxable when converted to Roth, and this fact will negate the advantage of this approach.

There is a way to avoid this pro-rata rule: if your company’s 401(k) plan or other retirement plan allows for transfer of traditional IRA values from outside the company plan to the plan (sometimes referred to as “roll-ins”), then all of those never-been-taxed IRA monies are no longer an issue, and the only dollars that would remain in the traditional IRA account would be after-tax dollars. In that case, there would be no taxes due on the conversion. Once those pre-tax amounts have been removed, the individual should continue to use this back-door approach every year that it is still available.

There are other planning opportunities for Roth conversions. If your account values in your traditional IRA values are currently depressed, now might be the best time to convert some of the funds and later enjoy the improvement in the account values within a Roth account. Then too, if you have large business or other losses that dramatically reduce your taxable income, that year would be the year in which to convert.

Seniors with variable income streams can take advantage of this fact and convert to a Roth in a tax-efficient manner. The trick is to convert as much as possible without thrusting yourself into a higher tax bracket. If you are filing as married, filing jointly in 2018, so long as your taxable income is less than $38,700, your tax rate is 12 percent – a bargain rate for a Roth conversion.

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