Q: If I convert an amount from my traditional IRA to a Roth, keeping me in a low tax bracket, and my financial adviser sells a bunch of stocks, leading to an unexpected gain that bumps me into a higher tax bracket, can I return the money to the traditional IRA to limit the tax liability for the year?
A.: Sorry to be the bearer of bad news, but the answer is “no.”
In 2018, as part of the Tax Cut and Jobs Act, “recharacterization” of Roth IRA conversions from traditional IRAs and qualified plans (e.g., 401(k)) were no longer permitted. As a result, all Roth conversions taking place on or after Jan. 1, 2018 are irrevocable.
Recharacterizing Roth contributions is still permitted. This would be the choice if you were to make a regular contribution (up to $6,000 for 2020, $7,000 if over age 50) to the wrong type of IRA and wanted it switched to the correct account.
The scenario you describe can be avoided with good communication and coordination. Talk to your adviser about the conversion before you execute it. Be aware though that while most “advisers” will talk about taxes, they will have a disclaimer that states that they don’t give tax advice. Many work at firms that prohibit them from preparing even the most basic tax projections. Some can critique a projection you create, but are still likely to avoid standing by any such critique. They will say, “see your tax adviser.” You should follow that suggestion, especially if you are not working with a financial planning and advisory firm that gives tax advice, coordinates the tax planning with the investments and stands by their tax advice.
It is easy to have the issue you describe even if you don’t use an adviser. Recharacterizations of Roth conversions were a staple of tax planning for years so one could be unaware of the change. A conversion done earlier in the year can easily be forgotten when placing trades later in the year. A Roth conversion was a tactic touted frequently around the COVID-19 crash.
Getting bumped to a higher bracket is also possible without placing a trade at all. For instance, you could receive a bonus at the end of the year. Further, mutual funds must pay out net realized capital gains every year. Most of these capital gain distributions are paid in the fourth quarter. If funds you own pay out enough capital gain distributions, one can easily find their income higher than expected and desired effect of a Roth conversion diminished.
Converting IRA money to a Roth IRA when in a low tax bracket is a sound tax strategy. In most years, it is usually advisable to wait until the end of the year to execute a conversion because you can use more actual numbers than estimated numbers for income items when projection your taxes and have higher assurance that you will remain in a low bracket.
In years like 2020 when the market declines early in the year and you think a Roth conversion is appealing, one option is to err on the conservative side and convert some but not all of what you think you will want to convert in the year at that time. Later in the year, if in fact your income is low enough to make further conversions attractive, you can convert more at that time. The more you convert, the more tax revenue Uncle Sam collects so there is no limit to the size or number of conversions executed during the year.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.