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How to Prepare for a Roth Recharacterization

Jeff Brown

If you've been thinking about converting your traditional individual retirement account into a tax-free Roth, get a move on: to count in the 2016 tax year, the process -- a simple instruction to your fund company, bank or brokerage -- must be done before Jan. 1.

And it's worth remembering that the government offers an escape hatch: the right to "recharacterize," or turn your Roth back into a traditional IRA, then convert to a Roth again when conditions are more favorable. This right makes it easier to convert in the first place, knowing you could still benefit from a market plunge or tax cut from the Republican dominance of Washington.

[See: 10 Reasons to Save for Retirement in a Roth IRA.]

Would it make sense to convert now? Given the stock market's gains in recent years, many investors find their traditional IRAs are more valuable than ever. That means a conversion would be taxed to the max, since converted sums are added to taxable income.

"Each client's tax situation is different and must be considered in all financial decision-making," says Sallie Mullins Thompson, an accountant with her own firm in New York. "However, I generally do encourage my 50-something clients to consider converting a portion, over time, of their traditional IRAs to Roth IRA, to lower their tax liability during retirement."

Young investors, as well as those in retirement, can benefit as well if circumstances are right.

Traditional IRAs provide tax deferral on investment gains, and for many people a deduction on contributions. But withdrawals are taxed as ordinary income. Roth IRAs offer no break on contributions, but all withdrawals are tax free, including investment gains and the original contributions.

The law allows investors to convert traditional IRAs into Roths, but the converted sums are added to the year's income and taxed. The flood of conversion income can even lift the investor to a higher tax bracket, making the sting worse.

In a perfect world, an investor would convert during a temporary market plunge, when the sums involved are smaller and produce a smaller tax bill. But with stocks at all-time highs, that opportunity doesn't seem likely before the end of this year.

Still, some investors can make a conversion pay even now -- mainly those who are in a low tax bracket this year because their income is unusually low, or if they have an unusually large amount to claim in deductions.

Generally, a conversion pays if you think your tax rate at the time is lower than it will be when you take money out of your traditional IRA. By converting, you pay a low tax now to avoid a higher tax later. If you think your tax rate will fall later on, conversion may not make sense, since you'd pay a high tax now to avoid a low one in the future.

No one knows what rates will be years from now, but President-elect Donald Trump has vowed to lower income tax rates. Converting now could be more expensive than doing it when rates are lower.

[See: 7 Reasons to Invest in an IRA.]

Another factor to consider: Withdrawals from traditional IRAs, since they are added to income, can increase the portion of your Social Security benefit subject to income tax, while Roth withdrawals, since they are not added to income, don't do that.

An individual with income between $25,000 and $34,000 can be taxed on 50 percent of the benefit, or 85 percent if income is higher. Couples filing joint returns are taxed on 50 percent if income is $32,000 to $44,000, and 85 percent if income is higher. Those thresholds are based on adjusted gross income from the tax return, plus non-taxable interest earnings from things like municipal bonds, plus half of your Social Security benefit.

With a Roth you also won't face the requirement to start minimum required distributions after turning 70.5, as you would with a traditional IRA. And your heirs will not be taxed on withdrawals from a Roth they inherit from you, as with a traditional IRA.

So, when you put it all together, it may pay to convert even if your traditional IRA is at an all-time high. Search for "Roth conversion calculator" for tools to help you decide. "(Conversions) also make sense for younger people since paying the tax now (is better than) paying tax in the future on presumably a higher future value," says Irv Munn, accountant with Munn & Morris Financial Advisors of Dallas.

Convert only if you have other funds to pay the tax bill, so the Roth does not have to make up the tax bite before breaking even, he says.

Investors who have converted also have the right to reverse the process in a "recharacterization." Generally, that pays if your Roth has fallen in value since the conversion. By going back to the traditional IRA, you can avoid the tax bill and then convert again when conditions are better.

A recharacterization can be done as late as Oct. 15 of the year after the conversion. To reconvert, you must wait until 30 days after the recharacterization, or until the next year, whichever comes later. However, you can convert from a different IRA with no waiting period.

"If your Roth conversion incurred a substantial drop in value, you may want to recharacterize and undo the Roth conversion," says Peter Nigro, chairman of the Finance Department at Bryant University in Smithfield, Rhode Island. "Alternatively, if the funds grew, you will want to keep the conversion."

Since markets are up in 2016, it probably won't pay to recharacterize a conversion done this year, unless, perhaps, you find your tax rate is much higher than expected, or you don't have the cash to pay the tax. But if you're thinking of converting, it's worth keeping this second chance in mind. Knowing you can undo it could make it easier to decide to convert in the first place, and a market plunge later is always possible after a long bull market and with a lot of uncertainty in Washington.

"If the Roth IRA decreases in value, such as through a stock market downturn, you would want to recharacterize the conversion," Munn says.

"You could then do a new conversion and only pay tax on the reduced value.on the taxable portion of your traditional IRA for the year of the conversion. The amount of income tax you pay is based on the value of your IRA on the date you converted it. Therefore, you may want to recharacterize your contribution to a Roth IRA if your Roth IRA decreases in value (e.g., through a stock market downturn) after the conversion date," he says.

[Read: 5 New 401(k) and IRA Rules for 2017.]

"You may also want to undo your conversion simply because you need the tax money for some other reason.on the taxable portion of your traditional IRA for the year of the conversion. The amount of income tax you pay is based on the value of your IRA on the date you converted it. Therefore, you may want to recharacterize your contribution to a Roth IRA if your Roth IRA decreases in value (e.g., through a stock market downturn) after the conversion date. You may also want to undo your conversion simply because you need the tax money for some other reason. You may also want to undo your conversion because you need the tax money for some other reason."



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