More On Tax Planning
from The Advisor's Professional Library- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
As values in your clients’ accounts drop post-Roth conversion, they may be able to save on their tax bills by doing a Roth reconversion. Clients that did a Roth conversion will be taxed on the value of the converted amount at the time of the conversion. If the value of the account drops post-conversion, they may be taxed on an amount that is much higher than the value of the account at tax time.
The good news is that there’s a way to reverse the Roth conversion and reconvert at the lower account value, saving on income taxes in the process.
Before a Roth reconversion can be done, the Roth account must be recharacterized as a traditional IRA. The account can then be reconverted to a Roth account. The trickiest part of a reconversion is getting the timing right.
First, recharacterization from a Roth to a traditional IRA must be completed by Oct. 15 of the calendar year after the conversion. Second, an amount that was converted to a Roth and then recharacterized as a traditional IRA cannot be reconverted to a Roth in the year of the first conversion; you’ll have to wait until at least Jan. 1 of the next year. Also, you’ll also have to wait 30 days from the recharacterization before you reconvert from a traditional IRA to a Roth.
A lot can happen between the recharacterization and the reconversion, so you’ll need to decide whether you believe that the post-conversion losses in the account will stand until the reconversion can take place. If you recharacterize to a traditional account and then the account rebounds higher than its previous value, you’ll end up with a bigger tax bill. As a result, it often makes sense to wait to recharacterize the Roth until the end of the year.
For example, suppose Client converted his $100,000 traditional IRA to a Roth in March of year 1. If the account loses 50% of its value by August of year 1, Client will still be taxed on the full value of the account, $100,000, despite the fact that the account is now worth only $50,000.
A recharacterization is probably in order for Client. But if the conversion is done too early, it could end up costing him more in the end. If, for instance, the reconversion to a traditional account happens in September of year 1, he will have to wait until January of year 2 before he will be allowed to reconvert to a Roth account. If the account holds highly volatile stock that rebounds, picking back up its lost value and adding another $10,000, he will be taxed on $110,000 instead of the original $100,000.
As a result, it often makes sense to wait to recharacterize the Roth until at least Dec. 1 of the year of the original conversion. Then there will be only a 30 day lag between the recharacterization and reconversion, which decreases the likelihood of significant movement before the reconversion can be accomplished. But no matter when the recharacterization is done, clients must understand that reconversion is a gamble they could lose.
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