Like aircraft flying at very low altitudes, the US tax code does strange things when very low incomes are involved. Most people know about, or have at least heard of, the earned income credit, which phases in quickly as “earned income” (which includes wage and self-employment income) rises, then phases out somewhat more slowly.
I think that’s bad program design, since it creates a weird higher marginal tax rate in the phase-out range, which then drops again when the credit is fully phased out, and I think the tax code should feature steadily rising marginal tax rates, not ones that bounce around all over the place, but economists like these “phase-outs” and the economists won.
If the earned income credit has an unfortunate design, it’s nothing compared to the retirement savings contributions credit, which has two abrupt adjusted gross income thresholds that reduce the value of the credit by 60% and 50% at $18,501 and $20,001, respectively, for single filers, before being eliminated completely at $31,001 in adjusted gross income. Those cutoffs have no economic rationale, but presumably they reduce the cost of the program since low-income folks tend to have more volatile income and will bounce around between the income bands.
These cutoffs mean fine-tuning your adjusted gross income can make an enormous difference to your total tax liability, and IRA recharacterizations are a great way to fine-tune your adjusted gross income.
The 2017 tax reform did not affect recharacterizations
This gets a bit confusing, since there was a change in the 2017 tax bill that affected a particular tax planning strategy involving IRA’s. That strategy involved transferring a tax-deductible traditional IRA balance into an after-tax Roth account, then reversing the transaction if the account fell in value before the tax filing deadline, a sort of heads-I-win-tails-I-win method of managing current and future income tax liability.
That strategy was eliminated by Congress in the 2017 tax reform bill by stipulating that Roth conversions cannot be reversed: if you convert a traditional IRA to a Roth IRA, you are liable for income taxes on the amount of the conversion whether the Roth account rises or falls in value.
All of this is made even more confusing by the fact that people use the terms “conversion” and “recharacterization” interchangeably. In this post I’m calling converting an existing traditional IRA balance into a Roth IRA account a “conversion” and redirecting an IRA contribution to a different account type a “recharacterization.”
And there was no change to the ability to recharacterize contributions, which can be done in either direction: contributions to a Roth IRA can be recharacterized as contributions to a traditional IRA, and vice versa (subject to Roth IRA income limits).
Recharacterizations were intended for high-income taxpayers
Since Roth IRA contributions can only be made by taxpayers with modified adjusted gross incomes below a relatively low limit ($133,000 for single filers in 2017), but many people (in my view, rightly) make weekly, biweekly, or monthly contributions throughout the year, there needed to be some mechanism for taxpayers whose income turned out to be above the contribution threshold to correct their mistake.
That mechanism is the recharacterization, whereby a contribution (legal or illegal) can be recharacterized from one account type to the other. In a recharacterization, both the original contribution and any earnings or losses on the contribution are transferred, meaning it’s irrelevant which account type you contribute to during the year: whether it gains or loses value, in a recharacterization everything is calculated as if you had made the contribution to the other account type in the first place.
Recharacterizations are great for fine-tuning low incomes
Low-income workers are the biggest beneficiaries of Roth IRA’s, since the “post-tax” contributions they make to them are generally “post” a tax of $0. That means they feature the enormous benefit of tax-free contributions, tax-free internal compounding, and tax-free withdrawals. A good deal!
But due to the “ground effects” of the retirement savings contribution credit I described above, it can be extraordinarily valuable to fine-tune the income of low-income workers, since the difference of a dollar in adjusted gross income can mean the difference between a credit that covers your entire tax liability and one that leaves you owing $418!
That means a low-income worker’s “core” retirement savings account should be a Roth account, but with a traditional IRA on the side to fine-tune their AGI before filing their taxes each year.
My 10-minute recharacterization call with Vanguard
I made very slightly more money in 2017 than I did in 2016, and when I plugged my numbers into Free File Fillable Forms my adjusted gross income was about $4,900 over the $18,500 threshold needed to claim the maximum retirement savings contribution credit.
This was a purely unforced error. I have a solo 401(k) for my self-employment activities, into which I split contributions 50/50 between the pre-tax and Roth subaccounts. If I had made only traditional contributions, I would have been just a few bucks away from the $18,500 target and could have just topped up the traditional account with retroactive contributions, which is what I’ve done in previous years.
But five grand is a lot of money, and I’m poor, so it was time to learn about recharacterizations.
Once I’d identified the precise dollar amount I needed to recharacterize, I called Vanguard, where my Roth IRA is held. After the security questions, I told the agent what I needed to do and he immediately understood. Since I didn’t have a traditional IRA with Vanguard, he told me to open one online while he waited. After I reached the confirmation screen, he refreshed his view and saw the account.
After I told him the amount of the 2017 contribution I needed to recharacterize, he plugged it into his computer and immediately returned with the amount of earnings on that amount (2017 was a good year).
Note that you have the option to identify specific contributions to recharacterize. I had 52 (give or take) contributions in 2017 so didn’t bother with specific identification, but it’s an option that’s available if you want to recharacterize only the most-appreciated or least-appreciated contributions (most-appreciated if you’re recharacterizing to Roth, least-appreciated if you’re recharacterizing to traditional).
Then he asked me which securities in my Roth IRA I wanted to move. Vanguard moves securities in-kind internally, so you don’t have to sell to cash before recharacterizing. I told him to move all my TIPS and take the remainder from my Vanguard 500 holdings.
Since I held Admiral shares of the Vanguard 500, he warned me that Vanguard would eventually downgrade them to higher-cost Investor shares unless I topped up the balance to the $10,000 minimum.
The entire call, including opening a new traditional IRA account, took 10 minutes.
As I’m fond of saying, the overwhelming majority of financial advice is targeted at people who can afford it and don’t need it, rather than people who need it and can’t afford it.
The retirement savings contribution credit is the major tax benefit available to filers who make too much to qualify for the earned income credit, and claiming the maximum benefit is the easiest way most low-income filers have to increase the amount of their federal income tax withholding returned to them as a refund each year.
IRA contribution recharacterizations are an easy way to maximize the amount of your retirement savings permanently shielded from taxes, while also giving your savings as much time as possible to work in the markets.