Undo Roth IRA Conversion: Limited Tax Savings Window

For a long time, converting your traditional IRA to a Roth version was a fairly low-risk proposition. If you changed your mind at a later date, you could always reverse course.

That all ended with the tax bill President Trump signed in December 2017. The legislation ends your ability to “recharacterize” your Roth conversion back into a traditional, SEP or SIMPLE IRA, beginning in tax year 2018. It does the same for Roth IRA funds rolled over from 401(k) and 403(b) accounts. (For more on SEPs and SIMPLE IRAs, see How does a Simplified Employee Pension (SEP) IRA work? and our SIMPLE IRA Tutorial.)

But there is a brief period – until October 15 of this year – in which you can still undo a 2017 Roth conversion. And for a lot of taxpayers, taking advantage of that window might lead to a nice tax break.

With a traditional IRA, savers contribute on a pre-tax basis and pay ordinary income tax rates when they withdraw the funds in retirement. A Roth account offers similar benefits, but in reverse; you pay ordinary taxes now in order to make tax-free qualified withdrawals down the road.

Switching to a Roth makes the most sense if paying Uncle Sam now results in a lower tax liability overall. Because of the recent reduction in tax rates, that may not be the case for some people who performed a Roth conversion in 2017.

Take, for example, a married couple who converted their $200,000 traditional IRA account – consisting entirely of pre-tax money – into a Roth in 2017. Let’s further suppose that they had $100,000 of other taxable income.

Under the previous tax law, their $200,000 account would have been subject to a 33% income tax rate. (Anything you reclassify as a Roth gets added to your adjusted gross income for tax purposes.) The conversion alone would result in a $66,000 payment to Uncle Sam.

Figure 1. The Tax Cuts and Jobs Act lowers marginal tax rates for individuals (although the new rates are set to expire in 2025).

Source: Tax Cuts and Jobs Act

Unwinding that conversion before October 15 might be a wise move. If the couple redoes the Roth conversion in 2018 at today’s lower rates they could save some serious bucks, assuming their account balance remains unchanged.

Their $300,000 in taxable income (including $200,000 from the conversion) would now put them in a more lenient 24% tax bracket. Suddenly, their conversion costs them just $48,000 – a savings of $18,000.

Of course, the bigger the amount you’re converting, the bigger the advantage of performing a Roth conversion at today’s lower rates.

There’s a big caveat here, however. If your IRA experiences a significant increase in value over the next few months, you may be better off keeping your 2017 conversion in place. Sure, you paid slightly higher rates back then, but you did so on a smaller pot of money.

This is one time when procrastinating actually pays off. By waiting until the October deadline looms, you can let the market play itself out for awhile longer. At that point, you can run the numbers, or have your financial advisor do so, to get a better idea of whether the recharacterization makes sense.

Keep in mind that the individual income tax cuts just passed into law are set to expire after 2025. Barring an additional action by Congress, they’ll bounce back up again. Therefore, if you do end up undoing your Roth, you might want to redo it in the next several years, when rates are relatively low.

Remember that you don’t have to convert all your funds at one time. You can limit your tax hit by spreading out the process over multiple years, converting just enough to stay in your current bracket. (For more on conversions, see Converting Traditional IRA Savings to a Roth IRA and 6 Reasons Not to Recharacterize Your Roth IRA.)

The days when you had the flexibility to undo a Roth conversion are a thing of the past for most taxpayers. But if you converted your traditional, SEP or SIMPLE IRA to a Roth IRA in 2017, you have until October to get a do-over at today’s lower rates.