Tax-time Roth IRA strategies

Tax time is a good time to review Roth IRA tax strategies with your clients.

One of the best deals in the tax code is a Roth recharacterization because it provides a second chance for clients to change their minds about their 2015 Roth conversions. It allows a Roth conversion to be undone.

The Roth recharacterization takes substantial tax risk out of the Roth conversion decision. It is one of the rare second chances granted by the tax code. In the simplest of terms, a Roth IRA recharacterization is an “undo.” In volatile economic times, like right now, tools that allow a do-over are more valuable than ever. It erases the Roth IRA conversion, as if it never occurred.

Tax time is a good time to evaluate a client’s 2015 Roth conversion to see if part or all of it should be reversed. While the topic should be addressed now, the final decision does not have to be made now. Clients have until Oct. 17, 2016, to recharacterize a 2015 Roth conversion. That gives clients plenty of time to make the final call. A recharacterization can be done for any reason at all.

Why would a client want to recharacterize? The main reason people voluntarily recharacterize is because the account has declined in value. A recharacterization cancels out the conversion and the conversion tax is eliminated. When tax time rolls around, clients sometimes get a case of buyer’s remorse and don’t want to pay the tax on the conversion, and that’s perfectly OK.

How do you recharacterize? Since a recharacterization reverses a Roth conversion, you would have to transfer the converted funds back to a traditional IRA, and that transfer must be done as a direct trustee-to-trustee transfer. The funds must go directly from the Roth IRA to the traditional IRA. You cannot withdraw the converted funds from the Roth IRA and then deposit them back into the traditional IRA. You can do either a full or partial recharacterization.

Clients who wish to file by this year’s April 18, 2016, deadline can do so and then recharacterize later (before Oct. 17, 2016). In that case, they would file an amended return and get their tax money back, plus interest.

BACKDOOR ROTH IRA CONVERSION

First, don’t call this a backdoor Roth conversion. It’s two separate transactions and should be treated as such. It’s a contribution to a nondeductible IRA and a Roth conversion. It has become known as a backdoor Roth conversion because it results in having the contributed funds end up in a Roth IRA even if income was too high to make a Roth IRA contribution.

If you are advising this strategy for your clients, be aware of the following four cautions:

• The client must have earned income — such as wages or self-employment income, or even alimony.

• You cannot be over age 70½ (traditional IRA contributions can no longer be made for the 70½ year and later years).

• The pro-rata rule will apply. All your traditional IRAs, including SEP and SIMPLE IRAs, are included in the pro-rata calculation. This could mean that some of the back-door Roth conversion will be taxable if there are other pre-tax funds in any IRAs. That’s still not a bad thing because that tax would have been paid anyway eventually, and now more money is growing tax free in the Roth IRA.

• The funds that end up in the Roth IRA through a backdoor conversion are converted funds, NOT Roth IRA contributions. This makes a difference for those under age 59½ because those funds must be held for five years to be withdrawn penalty-free. If the funds went in as a Roth IRA contribution, they could be accessed immediately, tax- and penalty-free.

Roth money should be for the long-term; so hopefully anyone using the backdoor Roth strategy will not be withdrawing before age 59½.

Here are three other tax-time reminders when it comes to making Roth (or traditional) IRA contributions:

1. Catch-up contributions
Don’t forget about “catch-up” contributions. Anyone age 50 or over during the last year who qualifies for a Roth IRA contribution (or IRA contribution) can add $1,000 to their 2015 contribution, allowing $6,500 to be contributed for the year.

2. Spousal IRA contributions
Don’t forget to look into spousal IRA contributions based on the income of the working spouse, provided they file a joint tax return and have sufficient earned income to cover the contributions for both spouses. The non-working spouse must still be eligible, though: under the income limit for Roth IRA contributions and the age limit for traditional IRA contributions.

3. No extensions
Remember that 2015 IRA or Roth IRA contributions must be made by April 18, 2016. There is no extension, even if the client files an extension for their tax return.

Share these timely IRA reminders with your clients’ CPAs, too.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.