What Is a Reconversion?
Reconversion was a method used by individuals to minimize the tax burden of converting an IRA by recharacterizing Roth IRA-converted amounts back to a traditional IRA and possibly converting these assets back to a Roth IRA again.
The goal of a reconversion was to help the taxpayer save money on the potential costs of converting an account by setting the amount to be taxed at the reconversion value, not the original account value. However, as a result of the Tax Cuts and Jobs Act of 2017, the strategy of recharacterizing from a Roth conversion back to a traditional IRA was banned.
- Reconversion was a method of converting an IRA by recharacterizing Roth IRA-converted amounts back to a traditional IRA.
- During a conversion from a traditional IRA to a Roth IRA, individuals must pay income taxes on those funds converted to a Roth.
- A reconversion allowed taxpayers to change their minds and reconvert the funds back to a traditional IRA if there was a tax benefit.
- However, the Tax Cuts and Jobs Act passed in 2017, banned recharacterizing from a Roth conversion back to a traditional IRA.
Understanding Reconversion and Recharacterization
Each year that a contribution is made to an IRA, the account holder has the choice to recharacterize that year's IRA contribution from a Roth IRA to a traditional IRA, or vice versa. The deadline to do a recharacterization is that year's income tax deadline.
Individuals might recharacterize their contribution because they might have realized they were ineligible to receive the tax-deduction from their contribution to a traditional IRA. The person might also realize they don't need a tax deduction that year because they have other deductions. Regardless of the reason, the person could recharacterize the traditional IRA contribution to a Roth IRA, and it would count as a contribution to a Roth for that same tax year. The person would receive the benefit of a Roth, such as tax-free growth and tax-free withdrawals in retirement.
Individuals also have the option to convert the funds within a traditional IRA to a Roth IRA. However, because the initial contributions benefited from a tax deduction, the individual would need to pay income taxes on those funds converted to a Roth. Remember, a traditional IRA gives a taxpayer a tax deduction in the year they make the contribution. However, Roth IRAs don't offer the immediate tax deduction, but funds can be withdrawn tax-free in retirement, unlike distributions from traditional IRAs, which are taxable income in retirement.
In the past, a person could recharacterize that Roth conversion back into a traditional IRA account. However, the Tax Cuts and Jobs Act was passed in 2017, and one of the provisions banned recharacterizing Roth conversions back into traditional IRAs.
Reconversion was utilized since it offered individuals the option to change their mind and recharacterize the money back to a traditional IRA. Let's say, as an example, that a person wanted to convert their funds totaling $50,000 to a Roth IRA. The entire amount of $50,000 in the traditional IRA would be taxable in the year of the conversion to a Roth. Let's say that the investment within the IRA declined in value to $25,000 before the tax-filing deadline. The person would still owe taxes from the conversion for the full $50,000 at the end of that tax year.
In other words, they'd be taxed on $50,000 for converting to a Roth but only have $25,000 in the account at the end of the year. In the past, individuals could do a reconversion and reconvert the newly-created Roth IRA back into a traditional IRA, and the taxpayer wouldn't owe income taxes on the $50,000.
However, as stated earlier, reconversion is no longer an option for individuals due to the passage of the Tax Cuts and Jobs Act of 2017.