Roth IRAs: converting, recharacterizing and reconverting.

Undoing a Roth IRA conversion can make a good thing even better.

If Roth IRAs are such a good idea, why undo a Roth IRA conversion? For a better bottom line, of course. Under some circumstances, such "recharacterizing" can result in significant tax savings. Although much has been written about the tax benefits of Roth IRAs, including the choice qualifying taxpayers have to convert traditional IRAs to Roth IRAs, one feature--passed as part of technical corrections to the Taxpayer Relief Act of 1997 (TRA '97)--has received considerably less attention. It allows taxpayers to undo Roth IRA conversions if circumstances warrant it. For certain clients, CPAs will find taking this step can make a good thing even better. Examples included in this article demonstrate the various uses and timing of conversions, recharacterizations and reconversions.

Clients should consider recharacterizing a Roth conversion when

* There has been a postconversion decline in the market value of the Roth IRA.

* The client anticipates a lower tax rate to apply in the year after converting to a Roth IRA.

A recharacterization also is appropriate if the client needs to correct a failed or invalid Roth conversion.

IF THE VALUE DIPS

When a taxpayer converts a traditional IRA to a Roth IRA, he or she must report all previously untaxed amounts from the traditional IRA--generally the market value on the date of conversion less any nondeductible contributions--as income in the conversion year. (Rules unique to 1998 conversions allowed taxpayers to spread the resulting conversion income over four years.) Consequently, most taxpayers would prefer to convert at the lowest possible market value.

Taxpayers may recharacterize until the due date (including extensions) of the tax return for the year in which a Roth conversion is made. (For 1998 tax returns that were filed on or before April 15, 1999, the IRS will allow taxpayers to recharacterize any Roth conversion up until October 15, 1999--provided the taxpayer files an amended return no later than April 15, 2002.) A recharacterization election reverses the Roth conversion and turns the account into a "new" traditional IRA. A taxpayer can then reconvert that new IRA to a Roth IRA, provided he or she meets the eligibility requirements in the reconversion year. This series of transactions allows taxpayers to reconvert to--and pay taxes on--the lower market value, as shown in the following example.

Example 1. In July 1999, Sandy converted her $40,000 traditional IRA to a Roth IRA. By October 1999, with the account at $32,000, Sandy can transfer the $32,000 to a new traditional IRA and declare the original transaction to be a transfer between two traditional IRAs. Sandy can then reconvert the new traditional IRA to a Roth IRA--assuming she has decided having a Roth IRA is still more beneficial--and pay tax on $32,000 instead of $40,000. By taking these steps, Sandy will have transferred her retirement investments to a Roth IRA but will report $8,000 less income on her 1999 tax return.

When an account declines in value after it is converted to a Roth IRA in 1999, there is an advantage to recharacterizing and reconverting--going from a Roth IRA to a traditional IRA and then to a new Roth IRA. The same is true for declines that follow a 1998 conversion when the taxpayer elected to report the entire taxable amount on his or her 1998 return. If the taxpayer elected to report the 1998 conversion over four years, he or she must weigh the tax benefits of reconverting at a lower value against the benefits of being able to spread taxable income over four years.

There are, however, restrictions. Once a taxpayer elects to recharacterize a Roth conversion it cannot be revoked or modified. This means that once Sandy moves her $32,000 into a new traditional IRA, her only option is to reconvert the account to a Roth IRA (or keep the money in the new traditional IRA). Taxpayers are restricted to one Roth reconversion during 1999. However, when an ineligible taxpayer makes a recharacterization to correct an improper or failed Roth conversion, the reconversion that follows it does not count toward this restriction. Since recharacterizing a valid Roth conversion leaves clients with one shot at reconverting to a Roth IRA in 1999, CPAs must help the client decide when to reconvert to achieve the greatest tax savings. Typically this will be when the account value is lowest--a difficult thing to predict in a seesaw stock market.

Example 2. Continuing with example 1, assume the value of the IRA on December 1, 1999, is at $29,000. Because Sandy already recharacterized and reconverted her IRA in October, when the market value was $32,000, she has used her one-time reconversion in 1999 and cannot take advantage of the further $3,000 decline in the account's value.

Taxpayers who recharacterize a Roth IRA after December 31, 1999, must wait until the later of 30 days after the transaction or the beginning of the tax year following the year in which they converted their traditional IRA to a Roth IRA before reconverting to a new Roth IRA. This rule means taxpayers who recharacterize beginning in 2000 must be at risk in the market for a minimum of 30 days before reconverting the new IRA to a Roth IRA. Any attempt to reconvert before the later of these two dates will result in a failed conversion (unless the failed conversion is recharacterized to a new traditional IRA in a timely manner, as explained in the example that follows).

Example 3. Joan converts her traditional IRA to a Roth IRA on December 10, 1999. On March 20, 2000, Joan recharacterizes the amount in her Roth IRA as a new traditional IRA. Since 30 days after the recharacterization is later than January 1, 2000 (the beginning of the tax year following the 1999 Roth conversion), Joan must wait until April 19, 2000 before reconverting to a Roth IRA. If Joan reconverts to a Roth IRA before April 19, 2000, the amounts transferred--less any amount that qualifies as a Roth contribution for 2000--will be subject to a 6% excise tax. Joan can remedy the situation by recharacterizing the remaining amounts back to a new traditional IRA.

Example 4. Stephen converts his traditional IRA to a Both IRA on February 10, 2000. He recharacterizes the Roth IRA to a new traditional IRA on August 27, 2000. Before he can reconvert to a Roth IRA, Stephen must wait until January 1, 2001 (the beginning of the tax year following the 2000 Roth conversion) since it is later than September 26, 2000. If Stephen reconverts to a Roth IRA before January 1, 2001, the amounts transferred less any amount that qualifies as a Roth contribution for 2000 will be treated as an excess conversion subject to the 6% excise tax. However, Stephen could remedy the situation by recharacterizing to a new traditional IRA the amounts that were inappropriately reconverted to the Roth IRA. He could then reconvert his IRA to a new Roth IRA on or after January 1, 2001, provided his adjusted gross income, was less than $100,000 in the year the reconversion took place.

ANTICIPATING LOWER TAX RATES

Recharacterizing and reconverting a Roth IRA may result in tax savings for clients whose marginal tax rate declines in the year following the Roth conversion.

Example 5. During 1999, Daniel converts his $30,000 traditional deductible IRA to a Roth IRA. Daniel will be in the 31% tax bracket in 1999. During 2000, but before the due date of his 1999 tax return, Daniel realizes his tax bracket in 2000 will be lower--only 28%. If Daniel elects to recharacterize his Roth IRA in 2000 and reconvert it to a Roth IRA after 30 days when the value of the IRA is $32,000, he will pay taxes of $8,960 ($32,000 x 28%). If Daniel does not make a recharacterization election, he will pay taxes of $9,300 ($30,000 x 31%). Assuming an 8% aftertax rate of return, the present value of the $8,960 in taxes he pays in 2000 if he recharacterizes is $8,296. Thus, Daniel would save $1,004 ($9,300 - $8,296) by recharacterizing his 1999 conversion and reconverting (and paying the income tax) in 2000.

CORRECTING A FAILED CONVERSION

When a taxpayer converts to a Both IRA in a year in which his or her AGI exceeds $100,000, or when a married taxpayer converts to a Roth IRA in a year in which the couple (regardless of income) file separate returns, the conversion is failed (invalid). If left uncorrected, the IRS will assess a 10% early-distribution penalty on the taxable portion of the distribution from the traditional IRA, unless one of the exceptions under IRC section 72(t) applies. In addition, a 6% excise tax will apply if the amounts improperly contributed to the Roth IRA--those that exceed the taxpayer's annual limit--remain in the IRA after the due date of the taxpayer's return (including extensions).

Treasury regulations specifically exclude a reconversion to correct a failed conversion as counting toward the one-reconversion restriction during 1999. (This exclusion rule does not apply to post-1999 recharacterizations.) Consequently, taxpayers who correct a failed 1998 conversion during 1999 are free to reconvert to a Roth IRA during 1999 and later recharacterize and reconvert the Roth IRA to take advantage of any subsequent decline in value of their Roth IRA.

Example 6. During 1998, Jane, who is not married, converted her $70,000 traditional deductible IRA to a Roth IRA. In 1999, Jane realized her 1998 AGI exceeded $100,000; she does not anticipate her 1999 AGI will exceed that amount. Jane filed her 1998 tax return on April 15, 1999. She has until October 15, 1999 to recharacterize her failed Roth conversion. She can then reconvert to a Roth IRA the new traditional IRA that was created when she corrected the failed 1998 conversion. If after reconverting, but before the end of 1999, the Roth IRA declines in value, Jane can recharacterize and reconvert to avoid paying taxes on the post-(re)conversion value.

Reconversions that follow corrective recharacterizations provide married taxpayers with an interesting opportunity. Married taxpayers who experience a decline in value in their Roth IRAs after recharacterizing a 1998 Roth conversion and reconverting in i999 can turn the 1998 conversion into a failed conversion by filing separately in 1998. This, in turn, will give the couple one additional opportunity to recharacterize and reconvert during 1999.

Example 7. During 1998, Harry Adams converted his $90,000 deductible traditional IRA to a Roth IRA. Harry and his wife extended the due date for their 1998 tax return until October 15, 1999; their AGI for both 1998 and 1999 does not exceed $100,000. In May 1999, when the value of the IRA had declined to $83,000, Harry recharacterized his Roth conversion and reconverted to a new Roth IRA.

In September 1999, the value of the Roth IRA declines further, to $75,000. If Harry and his wife file separate returns for 1998, the May 1999 recharacterization election will have corrected a failed conversion. Harry will then be free to recharacterize his Roth IRA again before October 15, 1999, and sometime later that year use his one-time reconversion, provided the couple files a joint return for 1999.

This series of transactions will result in the Adamses reporting $75,000 on their joint 1999 tax return, as opposed to reporting $22,500 ($90,000 / 4) on each of their 1998 to 2001 tax returns. However, the Adamses' CPA must help them compare the present value of the tax consequences of filing separately in 1998 and giving up the ability to spread the $90,000 income over four years against the present value of the tax consequences of converting $75,000 in 1999.

SOME ADDITIONAL CONSIDERATIONS

When a taxpayer's original Roth conversion occurred during 1998, the decision whether to recharacterize and reconvert requires weighing the benefits of avoiding the tax on the decline in value against forgoing the four-year spread on the income from the traditional IRA.

Example 8. Tim originally converted his $40,000 deductible traditional IRA to a Roth IRA in 1998 and elected to report the $40,000 over four years. In deciding whether to recharacterize his 1998 Roth conversion and reconvert in 1999, Tim needs to know how to compare the present value of the taxes he would pay on the $10,000 reported each year from 1998 to 2001 to the present value of the taxes he would pay on the amount taxable in 1999.

The exhibit above shows how Tim would benefit from recharacterizing his 1998 conversion and reconverting in 1999. It appears he would be better off by more than $1,800 if he recharacterizes and reconverts in 1999.

TIMING IS EVERYTHING

Recent rules regarding Roth IRAs allow taxpayers to recharacterize a Roth conversion and later reconvert back to a Roth IRA. For certain clients, this can result in big tax savings and still help them keep their retirement investment in a Roth IRA. However, practitioners must beware of the one-time reconversion limit imposed for 1999, and the minimum 30-day waiting period for all subsequent tax years. With the exception of any market risk involved with post-1999 recharacterizations and reconversions, clients will find the only downside to these new rules is determining the most opportune time to recharacterize and reconvert a Roth IRA.

RELATED ARTICLE: More from Roth

Senator William Roth (R-Del.), chairman of the Senate Finance Committee and author of the Roth IRA legislation, has introduced the Retirement Savings Opportunity Bill of 1999. To encourage individuals to save more for their retirement, it would

* Increase the IRA contribution limit to $5,000, from the current $2,000. (The contribution limit for SIMPLE IRAs would increase to $10,000, from $6,000, and the limit for traditional pension and 401(k) plans would go to $15,000, from $10,000.)

* Allow taxpayers nearing retirement age--defined as age 50 or older--to make an additional catchup contribution equal to 50% of the annual contribution limit to IRAs and qualified plans.

* Eliminate income limits for contributions to traditional and Roth IRAs--making them available to all taxpayers.

* Increase the income limit for converting from a traditional to a Roth IRA to $1 million, from $100,000.

* Allow qualified plan participants to make deductible contributions to traditional IRAs.

* Introduce Roth 401(k) and 403(b) plans funded with aftertax dollars that would provide tax-free distributions at retirement.

RELATED ARTICLE: Bankruptcy Protection?

As if the decision to convert a traditional IRA to a Roth IRA was not already complicated enough, in some states questions have arisen about whether Roth IRAs are protected from the claims of creditors in the event of a bankruptcy. It appears that in most states, Roth IRA proceeds are not protected. The glitch? Most state statutes that offer creditor protection to owners of traditional IRAs refer specifically to IRC section 408. Roth IRAs, however, are permitted under a new code section, 408A. At present, protection seems to be available only in states that don't refer specifically to section 408.

While this lack of protection may not discourage a taxpayer from making a $2,000 Roth IRA contribution, CPAs may want to think twice before recommending a sizable Roth IRA conversion to a client for whom creditor protection is an issue. This includes clients such as doctors and lawyers who are at risk of malpractice litigation as well as any client considering filing for bankruptcy. While state legislatures are likely to act to correct the problem, CPAs should check to make sure the appropriate change has been made in the client's state of residence.

RELATED ARTICLE: EXECUTIVE SUMMARY

* CONVERTING MEANS CHANGING A TRADITIONAL IRA into a Roth IRA for the first time. Recharacterizing means changing a Roth IRA into a new traditional IRA. Reconverting means changing a traditional IRA to a Roth IRA after a recharacterization.

* UNDER CERTAIN CIRCUMSTANCES, RECHARACTERIZING a Roth IRA can result in significant tax savings. A provision of the Taxpayer Relief Act of 1997 allows taxpayers to undo conversions, but there are limits.

* A REASON FOR RECHARACTERIZlNG A CONVERSION is that the value of the taxpayer's Roth IRA has declined. After recharacterizing to a traditional IRA, the taxpayer can reconvert the new IRA to a Roth IRA and pay taxes on the lower market value. Taxpayers are restricted to one reconversion during 1999. When a taxpayer makes a recharacterization to correct an improper conversion, the reconversion that follows does not count toward this limit.

* UNDER SOME CIRCUMSTANCES IT ALSO MAKES SENSE for a taxpayer to recharacterize and then reconvert a Roth IRA if the taxpayer's marginal tax rate has declined in the year following the Roth conversion.

* IF A TAXPAYER CONVERTS TO A ROTH IRA IN A YEAR in which his or her AGI exceeds $100,000, the best option is to correct this invalid, or failed, conversion by undoing the transaction. Otherwise, the IRS will assess a 6% excise tax on any excess distribution and may assess a 10% early distribution penalty.

RELATED ARTICLE: Converting a Traditional IRA to a Roth IRA

Eligibility to convert a traditional IRA to a Roth IRA is restricted to taxpayers with AGI at or below $100,000 in the year of the conversion. The $100,000 limit applies to unmarried taxpayers as well as to married taxpayers filing joint returns. Married taxpayers who file separate return are not eligible to make a Roth conversion. For purposes of the $100,000 limit, AGI is computed before considering the taxable amounts resulting from the Roth conversion.

The following methods are acceptable ways for taxpayers to convert a traditional IRA to a Roth IRA.

1. A taxpayer withdraws an amount from a traditional IRA and rolls it over to a Roth IRA within 60 days. Because the taxpayer has 60 days to complete the rollover, it is possible to withdraw amounts from a traditional IRA toward the end of one tax year and deposit them in the Roth IRA in the subsequent tax year. For purposes of determining both the year in which the eligibility requirements must be met and the year in which the taxable amounts from the traditional IRA are included in gross income, technical corrections to TRA '97 say that when a rollover spans two tax years, the conversion is considered to have taken place in the first year.

2. A taxpayer makes a trustee-to-trustee transfer of the amounts in a traditional IRA to a Roth IRA with a different custodian.

3. A taxpayer transfers amounts from a traditional IRA to a Roth IRA maintained by the same trustee. A taxpayer who uses this method is not required to make a physical transfer of assets. Thus, redesignating a traditional IRA as a Roth IRA is an acceptable practice.

Example. On December 14, 1999, Grant withdraws the $50,000 balance from his traditional IRA, which includes only deductible contributions. On February 10, 2000, Grant deposits the $50,000 in a Roth IRA. Although he did not complete the transactional until 2000, the Roth conversion is deemed to have occured in 1999. Consequently, Grant will report the $50,000 taxable amount on his 1999 tax return.

RELATED ARTICLE: Filing a Proper Recharacterization Election

A recharacterization involves transferring the amounts previously converted to a Roth IRA, plus any resulting income (or minus any resulting loss), to a new traditional IRA and electing to treat the amounts contributed to the Roth IRA as having been contributed instead to the new traditional IRA. A recharacterization election effectively reverses to the Roth conversion and replaces it with a transfer of funds from one traditional IRA to another.

To file a proper recharacterization election, the taxpayer must notify both the trustee of the Roth IRA and the trustee of the new traditional IRA--on or before the date of the transfer to the new IRA--of the election to treat the contribution as having been made to the new traditional IRA for federal income tax purposes. The election must also include.

1. The type of IRA (traditional, etc.) and the amount contributed to the Roth IRA that will be recharacterized.

2. The date on which the taxpayer originally contributed to the Roth IRA and the year for which the contribution was made.

3. Directions instructing the trustee of the Roth IRA to make a trustee-to-trustee transfer of the amount contributed pus any resulting net income (or minus any net loss) to the trustee of the new traditional IRA.

4. The names of the trustees of both the Roth IRA and the new traditional IRA.

RELATED ARTICLE: The Benefits of Recharacterizing When Electing a 4-Year Spread

Assumptions:

* Tim converted in 1998 and elected to pay taxes over four years.

* Tim is eligible to reconvert to a Roth IRA in 1999.

* Tim's tax rate for 1998 to 2001 will be 28% if he does not recharacterize, but will increase to 31% if he recharacterizes and reconverts in 1999.

* Tim earns an 8% aftertax rate of return.

       Tim does not recharacterize

         28% tax      Present value
        on $40,000   (8%) of the tax

1998      $2,800          $2,800
1999       2,800           2,593
2000       2,800           2,401
2001       2,800           2,223
Total                    $10,017

        Tim recharacterizes and reconverts

         31% tax      Present value
        on $32,000   (8%) of the tax

1998         0              0
1999      $9,920         $9,185
2000         0              0
2001         0              0
Total                    $9,185

LINDA M. JOHNSON, CPA, PhD, is associate professor of accounting at the Michael J. Coles College of Business, Kennesaw State University, Kennesaw, Georgia. Her e-mail address is [e-mail].3