NEW YORK (MainStreet) With national attention on the federal budget, debt ceiling and healthcare law, tax payers would be remiss in overlooking the October 15 deadline to complete an IRA recharacterization.
"To recharacterize is to take your traditional IRA that you have not yet paid income tax on and convert it to a Roth IRA or vice versa," said Dan McElwee, a certified financial planner with Ventura Wealth Management.
Investors can re-characterize their rollover or conversion by October 15 of the following year regardless of whether a filing extension has been requested. For example, for a conversion to a Roth IRA in 2013, investors have until October 15, 2014 to re-characterize.
"If you expect your tax rate to be lower in the future, you're better off leaving your traditional IRA alone rather than triggering any taxes now," said Paul Jacobs, a certified financial planner with Palisades Hudson Financial Group in Atlanta.
In a traditional IRA, investors receive an income tax deduction the year they make a contribution to the vehicle and pay income tax after withdrawing funds for retirement. In a Roth IRA, there is no current year tax deduction; however, all gains are income tax free at retirement under the current IRS Code.
"It's important for individuals to think about how their income stream will be structured during retirement," said McElwee. "Having the option to choose tax free income from a Roth IRA may be particularly beneficial for some individuals during their retirement years depending on their tax situation."
Savers can convert traditional IRAs to Roth IRAs, but taxes must be paid at the time of conversion.
"In a Roth IRA if your investments lose money in the first year, you have the ability to reset and pay tax on a lower amount because of the reduction in value of a bad investment," said Michael Goodman, financial advisor with Wealthstream Advisors.
The amount in the account will determine the tax bill.
"Recharacterizing from a traditional IRA to a Roth IRA will likely increase an individual's current income tax burden but seeing how every individual's income tax situation is different, the amount they pay in taxes will vary," McElwee said.
When unwinding a portion of converted assets pushes investors into a higher tax bracket, taxable income is determined based on the value of assets at the time of conversion.
"If 50% of the IRA assets are re-characterized and 50% remain converted, the taxpayer would only report half of the conversion amount at the time of conversion as taxable income," Jacobs told MainStreet.
Recharacterizations make sense for individuals who are relocating to a state with lower tax rates.
"They are a slam dank for workers who are currently in a low tax bracket now but expect to be in a higher tax bracket in the future," Goodman told MainStreet. "The younger you are using this strategy, the more tax-free growth you'll experience."
There are also tax benefits for heirs.
"When a taxpayer dies, his or her traditional IRA is subject to both income tax and estate tax," said Jacobs. "Although a Roth IRA is also subject to estate tax, heirs can receive the Roth IRA assets free of income tax."
--Written by Juliette Fairley for MainStreet