In this post, I will discuss how converting a pre-tax account at the start of a new year to a Roth IRA provides a “free” look at the market over the course of the year. If the market does NOT perform well, you can institute what is called a Roth Recharacterization so you do not have to pay the taxes on the conversion.

This post does get a bit “involved,”, so please feel free to ask any questions you have in the comments section.

The rest of this post will:

  • Review the Roth Recharacterization in more detail
  • Provide two examples to articulate if you should recharacterize
  • Summarize why this is something you should consider and why I am trying this strategy

Disclaimer: I am not a Certified Financial Planner™. What I write on this blog I research and share with you to enable you to go out and perform your own research and make your own decisions. Remember: trust, but verify!

What is a Roth Recharacterization?

If you are like me, you have no idea what taxes are going to look like in retirement. Implementing this strategy enables you to be able to test the market.

A Roth Recharacterization allows you to reverse a pre-tax conversion back to a Roth IRA. If you complete a Roth Recharacterization within the timeline for when your taxes are due, you can treat the account as a pre-tax account. You would NOT have to pay the taxes on the conversion.

Timing

You are allowed to make a Roth Recharacterization up to 6 months after your tax due date, which for most people is October 15th of the following year. Therefore, you could convert a pre-tax account to a Roth IRA in January of 2017. Depending on how the market performs, you could wait to make a Roth Recharacterization until October 15 of 2018.

However, it would behoove you to not wait until October 15 of the following year and make the decision whether to recharacterize at the end of the calendar year. More on this later in the post.

Why convert my Pre-tax Account a Roth IRA?

Simple – does it make sense from a tax advantage/savings standpoint.

You will have to pay taxes on the amount you convert – that’s a given. Where it becomes interesting is if  the market performs well and your investment grows significantly, do you make out better? And if it doesn’t, then what do you do?

Let’s take a look at a couple of examples.

Example 1 – market performs well

Here is one example. Let’s say my friend Sobhi has $10,000 in a Traditional IRA. After performing a quick Google search for “grounded engineer tax brackets” my article I wrote on calculating your tax bill pops up as the first link. Sobhi is married with a total family income of $100,000/year and files jointly. This puts Sobhi into the 25% tax bracket, which means he will pay $2,500 in taxes to convert his Traditional IRA to a Roth IRA (plus state taxes if applicable).

Sobhi completes the conversion in January of 2017. Remember, a conversion counts as ordinary income in the year it is executed. Now, let’s say the market performs well in 2017, and his investment grows by 10%. Now, his total investment sits at $11,000. He has until October 15 of 2018 to determine if wants to pay the $2500 tax bill. Or, Sobhi can institute a Roth Recharacterization.

In this example, it makes sense for Sobhi to keep the money he converted in a Roth IRA IF can afford the tax bill. Why?

  • The money will continue to grow tax-free. Sobhi will NOT pay taxes on any gains from investing his money in the Roth.
  • Sobhi will be able to pull out the money tax-free when he turns 59 1/2.

The only scenario I can think of where this would NOT make sense is the following. You plan to have enough money in your investment portfolio that you can already pull out tax-free. Or, you have A LOT of cash. Then, over time you can convert money in a Traditional IRA or 401(k) to a Roth IRA because your taxable income will be ZERO (other than what you convert).

Example 2 – market does NOT perform well

To keep things simple, much like the KISS (keep it simple stupid) methodology of investing I like to follow, I will use the same numbers for Sobhi from above.

However, instead of the market growing by 10%, the market goes down 10%. Now the $10,000 balance is only $9,000. You are footing the same $2,500 tax bill for what is now only worth $9,000. Therefore, your effective tax you are paying is 31% instead of 25%.

A Roth Recharacterization would be a good decision. You can wait to try this strategy out the following year!

A few more points:

  • Be careful to watch if the conversion pushes you into the next tax bracket.
  • You can also recharacterize from a Roth IRA to a Traditional IRA. You may want to do this for two reasons:
    • If you made too much money to contribute to a Roth IRA, you can still contribute to a Traditional IRA. However, in this instance you will NOT receive the tax deduction for the Traditional IRA.
    • You want to claim the tax deduction for the Traditional IRA
  • If you do not do a full conversion, you need to calculate the earnings or loss for a recharacterization. Check out the Investopedia article at the end of this post under sources.
  • Recharacterizations are not allowed in 401(k)’s, even though conversions occasionally are. So this free-look period does not work in a 401(k).
  • There is a minimum waiting period to reconvert the money to a Roth IRA if you recharacterized. You must wait until the later of:
    • 30 days after the recharacterization
    • the year following the year of the conversion

Because of these two timing constraints, you may not want to wait until October 15 of the following year to convert.

Summary

As I noted earlier, I am NOT a Certified Financial Planner™. So please complete your own research to see if this would make sense for your situation. Also, I provided a few links at the end of this post. Check them out because they discuss the importance of accurately calculating the amount you recharacterize (especially if you do not do a full conversion).

I like this strategy because it provides the ability to get a “free” look at the market, which enables me to make a better decision from a tax savings standpoint.

I did convert some money we had in a traditional IRA to a Roth to see how the market performs this year. If it doesn’t perform well, we will complete a Roth Recharacterization. I will be sure to update everyone on how this strategy worked for us!

Has anyone used this strategy before? Please share if you did!

Are there any other recommendations people have on this topic?

Sources:

http://www.investopedia.com/articles/retirement/03/092403.asp

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-recharacterization-of-roth-rollovers-and-conversions

https://www.irs.gov/publications/p590a/ch01.html#en_US_2016_publink1000230671

https://www.fidelity.com/viewpoints/retirement/how-to-reverse-a-roth-conversion