Considering Roth IRA conversions: is recharacterization a viable option for taxpayers?
Roth IRAs Versus Traditional IRAs
Roth IRAs were established in 1997 as an alternative tax-deferred investment vehicle to traditional IRAs and pension plans. In contrast to the back-loaded tax liability of such traditional investment options, Roth IRAs have a front-loaded tax liability--that is, instead of contributing pretax dollars to a fund where growth is tax free and distributions are fully taxed, Roth IRAs involve contributions of earned income net of tax with tax-free growth and tax-free distributions.
Many estate and financial planners favor Roth IRAs over traditional IRAs for numerous reasons, including the following:
* Assuming even a modest amount of investment growth, the overall tax liability is appreciably lower.
* Traditional IRAs are subject to required minimum distributions (RMD) in the year that the taxpayer reaches age 70 1/2, whereas Roth IRAs are not.
* Roth and traditional IRAs are generally valued equally for estate tax purposes, despite the fact that traditional IRA distributions are treated as taxable income to recipients, whereas Roth IRA distributions are tax free.
Although Roth and traditional IRAs are subject to the same annual contribution limitations ($5,500 for single taxpayers in 2013 or $6,500 for taxpayers who are older than age 50 in 2013), Roth IRAs are restricted to annual earned income levels of $112,000 (phasing out at $127,000) for single taxpayers and $178,000 (phasing out at $188,000) for married taxpayers filing jointly.
In 2006, the "Roth concept" was expanded to employee elective deferrals under 401(k) cash or deferred arrangements (CODA)--that is, "an arrangement under which an eligible employee may make cash or deferred election with respect to accruals or other benefits," according to the IRS (http://www.irs.gov/irm/part4/irm_04-072-002.html#d0e240). Where such 401(k) plans have been amended to allow for elective Roth contributions, the annual deferral limitations are much higher--$17,500 (or $23,000 for those age 50 or older).
Expanding the Scope of Roth IRAs
In 2010, the Hiring Incentives to Restore Employment (HIRE) Act materially expanded the scope of Roth IRA deferrals; this allowed conversion from traditional IRAs and certain pension plans to Roth IRAs without limitations on income level or filing status. Furthermore, taxable income created by a conversion in 2010 could be recognized across a delayed two-year period (2011-2012); thus, conversions were taxable largely in the year following a rollover (with the return).
Conversions from traditional IRAs, simplified employee pension (SEP) plans, or Savings Incentive Match Plan for Employees (Simple) IRAs (if held for at least two years) can be achieved through one of the following three methods: 1) a distribution from a traditional IRA that is rolled over into a Roth account within 60 days of distribution; 2) a trustee-to-trustee transfer from a traditional to Roth IRA; or 3) a transfer of accounts (traditional to Roth), where the same trustee maintains both accounts. In addition, 401(k) plan distributions such as in the year of termination, retirement, or upon reaching age 59V2--can also be converted.
With the enactment of the ATRA, the 401(k) rollover option was further expanded to allow plan participants to make in-plan rollovers, even when they are not eligible for a plan distribution as in prior years. Employers that offer 401(k) plans that have traditional features and Roth features may now allow employees to transfer amounts in their traditional accounts to their Roth account at any time, even if they are not eligible for a rollover. In order to offer this option to plan participants, however, the plans will need to be modified.
Given market volatility risks, taxpayers who have elected to convert eligible funds to a Roth IRA might experience a decrease in value of the underlying investments. These potential decreases can occur after electing conversion, but before the date when tax payments associated with the conversion are due. For such taxpayers, limited relief is available in the form of a recharacterization of the original conversion to an eligible rollover.
Requirements for Recharacterization
The decision to recharacterize should only be made after careful consideration by taxpayers and their advisors. Failing to strictly adhere to the rules of this process can result in a deemed taxable distribution of the fluids involved, triggering not only income taxes on the distribution, but also 10% excise (penalty) taxes and interest on unpaid taxes.
Several requirements are necessary for recharacterization. A trustee-to-trustee transfer of hinds that the taxpayer no longer wishes to convert must be completed no later than the due date of the tax return, including the six-month extension period. If the recharacterization is effectuated after the return has already been filed, taxpayers must file an amended return. Furthermore, a statement explaining the reversal must be attached to the return (or to the amended return).
Eligible transfers include those involving the same trustee, as well as custodial and account transfers. The amount of the transfer must be adjusted for any income or loss allocable to the funds that are not being converted (recharacterized). The following requirements must also be met in order to qualify for recharacterization:
* No deduction or adjustment could have been involved in the original conversion.
* The funds cannot be traceable to a Roth IRA.
* The trustees of the IRAs involved must be informed.
The recharacterization will require several filings, including Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts; Form 5498, IRA Contribution Information (detailing the amounts and earnings); and Form 8606, Nondeductible IRAs.
The following two examples are useful in illustrating recharacterizations.
Example 1. Assume that taxpayer Jacob Smith made a qualified rollover contribution, converting his traditional IRA to a Roth IRA of $100,000 in 2012. Assume that the earnings on this $100,000 are $20,000 from the time of the conversion to the time of recharacterization. Due to declines in the market, Smith does not have enough money to cover the entire associated tax bill, so he decides to undo half of this conversion. In order to do this, he must take 50% of the converted amount ($50,000), plus half of the earnings ($10,000), and transfer this entire sum ($60,000) from the Roth IRA back into a traditional IRA by engaging in a trustee-to-trustee transfer during 2013.
Once a Roth recharacterization is completed, the funds are treated as though they never left the traditional IRA: if the funds came from a company pension plan, they are treated as though they were directly rolled over to a traditional IRA. If a client is more than 70 1/2 years old, the total from which the RMDs must be calculated will also increase. This calculation is critical because failing to distribute the appropriate required minimum amount from a pension plan or traditional IRA can result in the imposition of a 50% excise tax penalty on the undistributed amount.
Example 2. Due to the state of the economy in 2009, the provisions mandating RMDs from traditional IRAs and pension plans were suspended; it is important to keep this in mind when considering the following example involving minimum required distributions and a recharacterization. Assume that taxpayer Anna Jones is 80 years old and has a traditional IRA with a balance of $1 million. After taking an RMD in 2012, she converts 50% of her IRA to a Roth account. Due to market losses in 2013, she realizes that she might need to withdraw funds from the converted Roth IRA over the next five years for personal living expenses; thus, she decides to recharacterize this conversion. Assuming that the earnings on the converted amount are $30,000 at year-end--thereby increasing the value of the balance by that amount--and that the remaining unconverted portion did not increase in value or suffer any losses, the RMD for 2013 must be calculated by taking all of these amounts into account: the original and reconstituted IRA total of $1 million, plus the $30,000 increase in value by the year-end date (i.e., a total of $1.03 million).
Avoiding Income Tax Liability
As noted earlier, one of the most valuable applications of the recharacterization rules occurs when the underlying IRA has dropped in value, due to market losses subsequent to conversion. Although this results in an income tax liability owed by the taxpayer on higher values that have since disappeared, individuals in such situations can rescind the conversion entirely through recharacterization; thus, the taxpayer can avoid paying taxes on income imputed from asset values that no longer exist.
Once a conversion is undone, or recharacterized, a taxpayer cannot choose to reconvert until the later of the beginning of the tax year following the original Roth conversion, or the end of a 30-day period that commences on the day the Roth conversion was recharacterized.
For example, assume that, in 2012, taxpayer Matt Johnson elected to convert 50% of his $200,000 traditional IRA to a Roth account. On April 15, 2013, Johnson extended the filing of his 2010 return. Due to market conditions as of June 30, however, Johnson's converted IRA balance of $100,000 dropped in value to $85,000. To avoid paying income taxes on the full value of the IRA (i.e., $100,000), he can recharacterize and rescind the June 30 conversion by making a trustee-to-trustee transfer (including profit/loss amounts netting to $85,000) and filing the appropriate information with his tax return. Doing so causes the original $100,000 to be treated as though it never occurred. Thirty days later, on July 30, Johnson can again elect to convert this lower amount of $85,000 to a Roth IRA, thus completing a Roth IRA conversion at a tax liability that is adjusted for the drop in value of the IRA. Once this is done, Johnson cannot recharacterize again until the following year (2014). This example demonstrates that when the market drop is substantial enough, a recharacterization makes sense.
Recharacterization mitigates a significant amount of the risk associated with conversion to a Roth IRA, especially if adverse conditions arise, such as market drops or cash flow limitations. Taxpayers and their advisors should familiarize themselves with this option, as well as with all of the requirements for achieving a tax-deferred rollover, prior to finalizing their Roth IRA conversions.
This article has been updated and adapted from "Reconsidering 2010 Roth IRA Conversions" by Magda B. Szabo, published in the Perelson Weiner Newsletter on Sept. 13, 2011.
Magda B. Szabo, JD, LLM, CPA, is a director of tax services at Perelson Weiner LIP, New York N.Y.
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|Title Annotation:||personal financial planning; individual retirement account|
|Author:||Szabo, Magda B.|
|Publication:||The CPA Journal|
|Date:||Jul 1, 2013|
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