October 15, 2018 is the filing deadline for individuals who requested an extension for filing their 2017 tax returns. It is also the deadline to reverse Roth IRA conversions performed during 2017. A Roth IRA conversion may be reversed even if the IRA owner’s 2017 income taxes have been filed.
This column discusses some tips for individuals who are recharacterizing 2017 Roth IRA conversions and those who required extensions for filing their 2017 income tax returns.
Reversing a 2017 Roth IRA Conversion
A Roth IRA recharacterization reverses a conversion from a traditional IRA to a Roth IRA as if the conversion never happened. With a recharacterization, any tax liability due on the conversion is in fact “forgiven”.
The recharacterization can be performed even if the 2017 federal income tax return has been filed. If the return was filed, then an amended tax return using Form 1040X will be filed showing the reversal of the conversion and a tax refund including interest. If a state income tax was filed, then an amended state income tax will have to be filed.
If the 2017 federal income tax return has not been filed, then the recharacterization can be incorporated into the 2017 federal tax return (using Form 8606) and no tax will be due on the original Roth IRA conversion performed during 2017. Some of the factors that should be considered before performing a Roth IRA recharacterization:
Value of converted account. If a converted Roth IRA has appreciated significantly (has gains) since it was converted during 2017 and therefore has a higher value now compared to the value when it was converted, then a recharacterization should not be performed. If a recharacterization were to be performed, then the taxable gains would be moved to the traditional IRA, resulting in a tax liability in 2018.
2017 tax rate. What was the tax liability for 2017 when the conversion was performed? Although individual tax rates have decreased starting in 2018 because of the Tax Cuts and Jobs Act of 2017 (TCJA), it may turn out that the 2017 tax liability due on a conversion was low because of substantial tax deductions, such as education credits and deductions and excessive medical expenses, that are will not be available in 2018.
2018 tax rate and how it will affect certain items. If there were no significant gains or losses on the 2017 converted Roth IRA funds, then it is important to compare one’s 2017 marginal tax bracket to one’s 2018 projected marginal tax bracket. Note that if a 2017 Roth IRA conversion is recharacterized, then the recharacterized traditional IRA can be reconverted after 30 days following the recharacterization. With an expected lower marginal tax bracket in 2018, the tax cost of a 2018 conversion may be lower, especially if there are any losses or deductions available in 2018 that were not available in 2017.
Also, the additional income associated with a 2018 Roth IRA reconversion may affect other items, taxability of Social Security and the increase in Medicare Part B premiums for annuitants, and affect the financial aid chances for children of employees who are attending colleges or universities.
Age. It makes sense for employees and annuitants turning age 70.5 during 2018 – that is, those born between July 1, 1947 and June 30, 1948 – to not recharacterize their 2017 Roth IRA conversions. The reason: Converting from a traditional IRA to a Roth IRA after age 70.5 becomes more complicated because of minimum required distributions (MRDs). MRDs in any year cannot be converted. That means if a traditional IRA in which the IRA owner is over age 70.5 is to be converted to a Roth IRA (not subject to MRD) then the MRD of the traditional IRA must be done before the conversion. The MRD process is complicated and can easily lead to errors. Therefore, a Roth IRA conversion performed during 2017 for IRA owners becoming age 70.5 during 2018 should not be recharacterized.
Tips for Filing 2017 Income Taxes
While the filing deadline nearing, there are still things individuals can and should remember to do to ensure they file a complete and accurate return. The following are a few tips for those Federal employees and annuitants who have not yet filed their 2017 Federal Income tax returns:
Try IRS Free File or e-file. Individuals can e-file their tax returns for free through IRS Free File. The program is available at www.irs.gov through October 15, 2018. IRS Free File is easy, safe and the most accurate way to file taxes.
File by October 15. Individuals with extensions should file their tax returns by Monday, October 15. If they owe, then they should pay as much as possible to reduce any interest and penalties. IRS Direct Pay allows individual to securely pay from their checking or savings accounts. These taxpayers can consider an installment agreement, which allows them to pay over time. Information about Direct Pay and installment agreements can be found at www.irs.gov.
More time for the military. Military members and those serving in a combat zone generally get more time to file their income tax returns. These individuals typically have until at least 180 days after they leave to a combat zone to file returns and pay any taxes due.
More time in certain disaster areas. Individual who have a filing extension and live or work in a disaster area often have more time to file. Information can be found at: https://www.irs.gov/newsroom/tax-relief-in-disaster-situations
Individuals owed a refund should use Direct Deposit. The fastest way for individual to get their refunds to combine Direct Deposit and e-file.
Individuals who have a balance due should pay as much as they can, ideally paying the entire balance due. A filing extension allows an individual to file his or her taxes as much as six months after the original filing due date of April 15. However, a filing extension is not an extension to pay a balance due. If for some reason the individual filer owes a balance due when the return is filed, the individual pay as much as he or she can, ideally all of it. But if the individual cannot afford to pay the balance due then the IRS has payment options that can be found at www.irs.gov. The worst thing that the filer can do is to ignore the problem and pretend the problem will “go away” with the thought that the IRS will never contact him or her about the balance due. Nothing can be further from the truth.