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US Tax Reform Impacts Roth Individual Retirement Account Conversions

HR 1 makes Roth IRA conversion recharacterizations a thing of the past, but is silent on whether recharacterizing 2017 Roth IRA conversions in 2018 will be permitted.

The December 22 tax reform legislation, HR 1, generally amends the Internal Revenue Code to reduce tax rates and modify policies, credits, and deductions for individuals and businesses, but also makes a key change that affects individual retirement accounts (IRAs) in relation to Roth IRA conversion recharacterizations.

Prior to the new legislation, commonly referred to as the Tax Cuts and Jobs Act, there were two types of permitted IRA recharacterizations. The first type of recharacterization permits an IRA owner to transfer annual contributions made to a traditional or Roth IRA during a tax year to the other type of IRA and to treat the contributions as annual contributions made to the other type of IRA. When the contributions are recharacterized, they are treated as having been made to the second IRA as of the date of the original contributions. This first type of recharacterization for annual IRA contributions was not changed by the new legislation and is still permitted.

The second type of IRA recharacterization—now eliminated by the new legislation—permitted an IRA owner to transfer conversion contributions that were made to a Roth IRA through a conversion from a traditional, SIMPLE, or SEP IRA or an eligible qualified retirement plan back to an eligible IRA, effectively canceling the Roth conversion. This type of recharacterization was helpful for IRA owners whose situations changed after the conversion contributions were made. For example, an IRA owner might have decided to recharacterize Roth IRA conversion contributions when the Roth IRA assets declined in value after the conversion or the IRA owner did not have the funds to pay the taxes due on the conversion. Section 13611(a) of HR 1 amends Section 408A(d)(6)(B)(iii) of the Internal Revenue Code to eliminate this second type of recharacterization and is effective for taxable years beginning after December 31, 2017.

The deadline for recharacterizing a contribution made in one tax year is the IRA owner’s tax-filing deadline plus extensions for the following year. Accordingly, the deadline to recharacterize an annual IRA contribution made in 2017 is October 15, 2018.

But what about recharacterizing a Roth IRA conversion contribution made in 2017? Some have questioned whether the new legislation permits Roth IRA conversion contributions made in 2017 to be recharacterized in 2018, given the December 31, 2017 effective date of the change. This issue is not addressed in the legislation or conference report and there has been no guidance issued by the Internal Revenue Service (IRS) to date. The IRS has apparently informally stated that Roth IRA conversion contributions made in 2017 are still permitted to be recharacterized in 2018 up to the October 15, 2018 deadline, but hopefully it will issue formal guidance confirming this soon.

Until the IRS does issue guidance on the recharacterization deadline for 2017 Roth IRA conversion contributions, recharacterizing these conversion contributions in 2018 carries some risk. If the IRS does not permit the recharacterization of 2017 conversions in 2018, a recharacterization in 2018 could result in adverse tax consequences for both IRA owners and IRA custodians and trustees. The IRA owner would be stuck with the tax consequences of the original conversion and owe taxes on the amount converted. The attempted recharacterization would subject the IRA owner to any 10% penalty tax due on distributions from a Roth IRA within five years after a conversion. The attempted recharacterization would also most likely be viewed as a regular IRA contribution to the receiving IRA. If the contribution exceeded the annual contribution limit for the year, the 6% excise tax for excess contributions would apply every year until the excess amount was withdrawn.

If the IRS does not permit recharacterization of 2017 conversions in 2018, the primary risk for IRA trustees and custodians is exposure to reporting penalties. But hopefully IRA trustees and custodians will have guidance from the IRS before the applicable tax reporting deadlines.

If the IRS issues guidance that permits recharacterizing a 2017 Roth conversion in 2018, with any luck it will do so in time for IRA owners to undo 2017 conversions by the October 15, 2018 deadline. This would be good news for IRA owners, trustees and custodians alike. We urge IRA owners and IRA trustees and custodians to stay tuned for additional IRS guidance on this topic.

Copyright © 2018 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

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About this Author

Sariyah Buchanan, Employee benefits plans attorney, Morgan Lewis
Associate

Sariyah S. Buchanan ensures that benefit plans and compensation arrangements comply with US state and federal laws including ERISA and the Internal Revenue Code. Sariyah drafts employment agreements, equity plans, grant agreements, and proxy materials, and prepares custodial agreements, disclosures, and election and beneficiary designation forms for IRA custodians. She assists clients in corporate transactions and represents clients before the IRS, PBGC, and DOL. Sariyah’s clients include startup and Fortune 500 clients in financial services, insurance, real estate,...

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Vivian S. McCardell, Morgan Lewis, Retirement Benefits Attorney, IRA Lawyer
Of Counsel

Vivian S. McCardell counsels clients on individual retirement accounts and annuities (IRAs) and similar products offered by financial institutions and broker-dealers, as well as qualified and nonqualified retirement plans. She helps clients address issues with nonbank custodians and trustees and other service providers. Additionally, Vivian advises clients on compliance with the US Internal Revenue Code, the US Employee Retirement Income Security Act (ERISA), and other federal and state laws that affect IRAs, and qualified and nonqualified retirement plans.

215.963.5810