Roth IRA Recharacterizations: It’s 2011 â Now What?
If William Shakespeare were to write a soliloquy on Roth IRAs in 2010,
one could envision Prince Hamlet asking, “To Roth, or not to Roth: That is the question.” Conceivably, Hamlet may continue by asking, “Whether ’tis better financially to suffer the up-front payment of tax to pass an outrageous fortune to heirs, or be cautious, in light of the slings and arrows of the unknown future sea of tax troubles that Congress could bestow?” If, in 2011, Shakespeare is now asked to write a follow-up soliloquy on Hamlet’s 2010 Roth decision, we suspect the prince may ask, “To recharacterize, or not to recharacterize: That is the question.” And he may continue by saying, “With the law’s delays of the year gone by, and with uncertainty on the horizon, what I am to do?” He probably won’t have to end his verse with, “Be all my sins remembered,”1 b ecause a Roth IRA can be recharacterized if done on a timely basis and in an appropriate manner (even if the sole purpose is to correct a mistake, or in Hamlet’s case, to rectify a sin).
Roth IRAs have been available since enacted by Congress as part of the Taxpayer Relief Act of 1997.2 A lthough popular before 2010, interest in Roth IRAs has grown exponentially due to the lifting of the $100,000 modified adjusted gross income cap that previously prevented high-income taxpayers from converting3 traditional IRAs (or other types of eligible retirement plans)4 to Roth IRAs.5 A dding to the appeal of Roth IRAs is the ability to “undo” or “recharacterize” a conversion. Since many clients converted for the first time in 2010, practitioners should be versed in the nuances of recharacterizations in order to properly advise their clients. In 2011, the questions regarding recharacterizations are likely to be:
• Should a Roth IRA be recharacterized?
• If so, when?
• How does one accomplish a recharacterization?
• Can a recharacterization be undone?
The purpose of this article is to provide a framework to help answer these questions.
Background on Conversions
Before looking at the issues specific to recharacterizations, the following will summarize the basic rules governing the federal income taxation of converting a traditional IRA account to a Roth IRA.6 C onverting a traditional IRA to a Roth IRA is treated as a distribution from the traditional IRA, the proceeds of which are includable in gross income at the value as of the date of the deemed distribution. Furthermore, the includable amount is treated as ordinary income.7 C onversions of after-tax contributions from a traditional IRA to a Roth IRA are not includable in gross income, since they previously have been taxed.8
For 2010 conversions only, taxpayers can choose between two methods to report and pay any income tax on the includable amount. Under the default rule,9 one-half of the taxable amount incurred on the deemed distribution of the traditional IRA is included in income in both 2011 and 2012, at income tax rates in effect during those years (two-year rule).10 The alternate recognition rule provides for full inclusion in 2010, provided an election is made no later than October 17, 2011. Note that a two-year election is not available for conversions after 2010, meaning income must be included in full on the return for such year.
Critical Deadlines, Forms, and Timing Issues
For 2010 conversions, the election to trigger inclusion in 2010 (versus spreading the inclusion under the two-year rule) is made on Form 8606 (nondeductible IRAs) by checking the box on line 19 for IRAs and/or line 24 for qualified retirement plans. If the two-year rule is desired, the appropriate amounts must be recorded on lines 20 for IRAs and 25 for qualified retirement plans, respectively.
Recharacterizations are permissible if done on or before the due date (including extensions) of filing his or her tax return.11 This is true, regardless of whether an extension is filed.12 For 2010 conversions, this means that recharacterizations can be done as late as October 17, 2011 (because October 15, 2011, falls on a Saturday).13 W hether reported on the initial or amended return, a separate statement explaining the facts surrounding the original conversion and recharacterization should be attached to the return. Bear in mind that separate rules govern the reporting of recharacterizations made in the year of conversion versus the year following conversion, and the reporting of partial versus full recharacterizations of amounts previously converted.14
An issue related to the timing of recharacterizations is planning to pay conversion tax liability on a timely basis to avoid any penalties. The timing and payment of the tax liability depends upon 1) when income will be recognized and 2) the amount of conversion income. In turn, the amount of conversion income depends upon whether part or all of the conversion will be recharacterized. Generally, to avoid the underpayment penalty, the tax for the conversion must be paid by April 15 following the year of conversion. Many planners advocate that if one is not sure whether a client will recharacterize by the time the tax payment is due, the taxpayer should pay the entire tax liability. If later the tax liability is lower than initially anticipated because of recharacterization, file an amended return to receive a refund or claim a refund on the initial return.
Conversions done in 2010 create an anomaly when the taxpayer chooses to defer income one-half into each of 2011 and 2012 ( i.e., the two-year rule) because this is the only circumstance in which the recharacterization decision must be made before the tax payment is due. For example, assume Hamlet converts his traditional IRA on January 10, 2010. Assume further that he decides to defer the recognition of income under the two-year rule. The decision to recharacterize any part or all of his conversion must happen by October 17, 2011. This means Hamlet will know exactly how much conversion income he will recognize in 2011 and 2012 (as a result of the 2010 conversion).
The related planning concern for 2010 conversions in which the taxpayer utilizes the two-year rule is ensuring that there are sufficient funds to pay the conversion tax. Because values can fluctuate widely after the deadline to recharacterize has passed, sufficient funds to pay the income tax when due in April 2012 and April 2013 should be segregated and held in safe, relatively stable investments. The point is that taxes are based on the value as of the date of the deemed distribution, not the value when taxes are paid. If markets underperform, locating funds to pay taxes on “fictitious” income based on previously higher values will be problematic on multiple levels.
How to Recharacterize?
The Treasury Regulations are clear that only trustee-to-trustee transfers qualify in order to make a proper recharacterization.15 In addition, for recharacterizations of less than an entire Roth IRA account, pro-rata income and loss must be accounted for in describing the amount to be recharacterized. The Treasury Regulations and IRS guidance provide a formula for computing income or loss associated with amounts previously converted.16
The ability to recharacterize is Congressional acknowledgement of buyer’s remorse.17 The analysis involves more than emotion, however. The decision depends not only upon income tax considerations, but also upon market performance and strategies employed at the time of the initial conversion.
• Income Tax Considerations — As with all investment and estate planning decisions, the net after-tax result is what matters. The decision to recharacterize is no different. One generally recharacterizes if the estimated or perceived net after-tax result of conversion is not as favorable as if the taxpayer converts at a later point in time. For example, Gertrude decides to convert her $1 million traditional IRA. Let’s assume that the top income tax rate in the year of conversion is 35 percent. If there is a change in tax law, and rates decrease to 30 percent, and if the asset does not change in value, generally Gertrude would recharacterize with the intent of reconverting later. She would save $50,000 in taxes ( i.e., the difference between 35 percent and 30 percent of $1 million), and with no change of value, the net after tax result of recharacterization and reconversion would be better (all other things being equal).
• Relative Income Tax Rates in 2011 and 2012 — Prior to the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010), the threat of rising tax rates played into the recharacterization decision because rates were scheduled to increase from 35 percent in 2010 to 39.6 percent in 2011.18 H owever, with the passage of TRA 2010 came the benefit of keeping the tax rates at 35 percent through 2012.19 A ccordingly, changing tax rates for 2010 is generally not a factor in the recharacterization analysis.20
• Change in Market Value — Probably the most compelling reason to recharacterize is if the assets inside the Roth IRA decline. Because, generally speaking, relative income tax rates are not part of the analysis for 2011 and 2012, the focus for that time period should be on periodic investment performance and volatility. When advising clients who are tempted to recharacterize due to a dip in market values, be aware that recharacterizations come at a cost because the ability to “reconvert”21 is limited.
There are two rules covering this issue. The first is when the initial conversion and recharacterization occur in the same year. In this situation, reconversion may not occur until the later of 1) January 1 of the next taxable year or 2) 30 days after recharacterization. The second rule is when the initial conversion takes place in one year, and the recharacterization occurs in the subsequent calendar year. In that situation, reconversion may take place 30 days after recharacterization.22
In advising clients on whether to recharacterize, you must always be informed of the rules regarding reconversions. If a client recharacterizes on a market dip, he or she may miss the bigger upside by having to wait out the period before the ability to reconvert becomes available. This is an area where attorneys and investment advisors can work closely together in formulating the best approach for clients.23
The following example may be instructive. Let’s assume Horatio converts his $1 million IRA on January 10, 2010. June 30, 2010, the Roth IRA has — because of market forces — decreased to $900,000. Horatio may want to “pull the trigger” and recharacterize at that time. The adviser, knowing the rules, may want to advise Horatio to wait until November 30 before considering recharacterization, because the client cannot reconvert until January 1, 2011. In this manner, Horatio would get a free look from July to November, and if asset values recover, then there is no downside. If the asset values are still low in November, then the recharacterization decision would have to be considered at that time.
• Enhance Structure of Roth IRA Holdings — In 2010, many clients were advised to use multiple Roth IRA accounts with the idea of recharacterization in mind. The idea was that one would maintain a separate sector or style of investment for each Roth IRA account. Using this approach, the thought was that only the Roth IRAs that underperformed would be recharacterized. Using multiple Roth IRA accounts is considered a superior strategy to only one account because declining investments would not offset the benefit of appreciating investments.24
In addition to using multiple accounts, clients were also advised to convert more assets with the intention of recharacterizing the following year.25 to illustrate, let’s assume that Gertrude has $3 million in a traditional IRA, but wishes only to convert $1 million to a Roth IRA. Instead of converting just $1 million, Gertrude can convert the entire $3 million from one traditional IRA into six $500,000 Roth IRAs, and each $500,000 tranche has a unique investment style in correlation to the other accounts. Before the recharacterization period ends, Gertrude can keep the two best performing Roth IRA accounts and recharacterize the four lowest performing accounts. Remember, the tax is based upon the value on date of conversion, regardless of the value of the account in the future. Using this strategy, Gertrude gets the full benefit of converting $1 million, and gets the benefit of 20-20 hindsight in making the decision of which accounts to recharacterize.
Finally, clients who did not segregate into separate Roth IRA accounts before initially converting can use the recharacterization rules to restructure their holdings. Of course, whether to recharacterize for this purpose requires a thorough analysis.
The decision of whether to recharacterize necessitates an understanding of the client’s full financial picture, including asset allocation and asset location concerns. Importantly, because there is a firm deadline to recharacterize, planners and clients should explore appropriate investment strategies soon. As King Lear imparted to his dear Cordelia, “Nothing can come of nothing: speak again,”26 so we advise you, the reader, to speak again to your clients this year to remind them of the recharacterization opportunity before it is too late.27
1 W m. Shakespeare, Hamlet, act three, scene one.
2 Taxpayer Relief Act of 1997 §302 (1997 act) added I.R.C. §408A (1986), as amended (code), effective for taxable years beginning after December 31, 1997. Unless stated otherwise, all section references are to the code.
3 For purposes of this article, the term “conversion” is used to mean qualified rollover contributions from an eligible retirement plan to a Roth IRA, as described in §408A(e)(1).
4 For purposes of this article, reference to traditional IRAs (contemplated by §402) includes all types of accounts listed in the definition of an “eligible retirement plan.” The term eligible retirement plan is defined in §402(c)(8)(B) and includes a Roth IRA, a traditional IRA, qualified pension, profit-sharing, stock bonus or annuity plan, tax-deferred annuity, or eligible deferred compensation. Although most of the rules applicable to IRAs are applicable to qualified plans, there are some exceptions beyond the scope of this article.
5 U nder the 1997 act, §408A(c)(3)(B) provided, in part, that a taxpayer could not make a qualified rollover contribution to a Roth IRA if the taxpayer’s adjusted gross income exceeded $100,000. This provision was eliminated in §512 of the Tax Increase Prevention and Reconciliation Act of 2005, effective for tax years beginning after December 31, 2009 (the 2005 act). Additionally, under the 2005 act, married taxpayers who file separate income tax returns were permitted to convert their traditional IRA to a Roth IRA (also effective for tax years beginning after December 31, 2009).
6 It is assumed that the reader has a basic understanding of Roth IRA contributions, conversions, distributions, recharacterizations, and reconversions.
7 & sect;§408A(d)(3)(A)(i) and (d)(3)(B).
8 T reas. Reg. §1.408A-4, Q&A-7. Nor does the 10 percent penalty amount under §72 apply on the conversion. It is important to note that it is the distribution from the traditional IRA that determines the income tax inclusion, not the amount that ultimately funds the Roth IRA. For example, if stock in a traditional IRA is valued at $100 on the date of distribution, but drops to $98 on the date of funding the Roth IRA, $100 must be included in gross income (assuming the taxpayer’s basis in the stock is zero). In the event that the taxpayer has both pre-tax and after-tax contributions in his or her traditional IRA, conversion of less than the entire amount of the taxpayer’s traditional IRA requires that pro-rata amounts of pre-tax and after-tax amounts are deemed converted.
9 & sect;408A(d)(3)(A)(iii).
11 & sect;§408A(d)(6)(A) and 408A(d)(7), and
Treas. Reg. §1.408A-5, Q&A6(b) provide that the recharacterization can be done as late as the last day for filing a return, as if the taxpayer had filed an extension (regardless if an extension had not been filed). In the event that the taxpayer fails to make a timely recharacterization, not all is lost. It may be possible to obtain relief for a late recharacterization through the private letter ruling process.
Treas. Reg. §301.9100-3. Note that it is not possible to recharacterize a conversion to a qualified Roth contribution program ( i.e., a so-called “Designated Roth Account”), such as a Roth 401(k) or Roth 403(b) plan.
13 If a return has already been filed before the recharacterization is done, file an amended return to reflect the recharacterization, and write “Filed Pursuant to section 301.9100-2.” The instructions to Form 8606 provide detail on the reporting of recharacterizations of part or the entire amount at issue.
14 See generally,
Treas. Reg. §1.405A-5.
15 T reas. Reg. §1.408A-5, Q&A-1. See also IRS Publication 590. Technically, the trustee of the plans must be notified. The notifications must describe the amount to be recharacterized, the date on which the conversion was initially made (and the year for which it was made), a direction to transfer the converted amount to the account which is to receive the recharacterized funds, and the names of the trustees, if the two are institutions. Importantly, the direction must contain instructions on the transfer of any net income or loss allocable to the amount recharacterized (discussed below).
16 N et income or loss = contribution ( i.e., amount converted) x (adjusted closing balance – adjusted opening balance) / opening balance. The adjusted opening balance is the fair market value of the Roth IRA when conversion is made, plus any amounts of additional contributions or conversions. The adjusted closing balance is the fair market value of the Roth IRA immediately prior to recharacterization plus the amount of any distributions or transfers. See Treas. Reg. §1.408A-5, Q&A-2 and Publication 590.
17 See §I(C)(1) of the Description of Chairman’s Mark of the Tax Technical Corrections of 1997, prepared by the Joint Committee on Taxation, October 8, 1997.
18 & sect;901 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).
19 Note that the tax rate analysis beginning in 2013 will involve what happens when the rates under the TRA 2010 “sunset.” TRA 2010, §101.
20 An example under the now obsolete EGTRRA rules (where relative income tax rates would be an issue in recharacterization) is if the taxpayer converted in 2010 and planned to pay income taxes using the two-year rule. If the portfolio underperforms or is flat, the taxpayer would have faced a higher income tax liability on the conversion than had he or she done nothing. In that case, the taxpayer should consider recharacterizing. Under the TRA 2010, this analysis is no longer relevant because income tax rates will be the same in 2011 and 2012 as in 2010.
21 R econverting is referred to when a taxpayer who previously converted a traditional IRA to a Roth IRA, recharacterizes the Roth IRA back to a traditional IRA, but then wishes again to convert back to a Roth IRA. Congress gives taxpayers a “do-over” in the form of recharacterizations and limits (but does not eliminate) “double-do-overs.”
22 T reas. Reg. §1.408A-5, Q&A-9.
23 See Andrew Huber and Lester Law, Asset Location: Why Attorneys Should Bridge the Perceived Investment Gap,
Fla. B. J.
24 The concept is similar to the thought of using sector-based or single class of stock GRATs.
25 For a summary and examples of the mathematics underlying the benefit of segregating assets into separate accounts, see Richard S. Franklin and Lester Law, Roth IRA Recharacterizations – 10 Strategies,
Tax Practice Tax Notes
(January 18, 2010).
26 W m. Shakespeare, King Lear, act one, scene one.
27 This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances.
Andrew Huber is a senior vice president and wealth strategist at U.S. Trust, Bank of America Private Wealth Management in Palm Beach. He received his J.D. from the University of Miami School of Law and LL.M. (tax) from the University of Florida College of Law.
Lester Law is a senior vice president at U.S. Trust, Bank of America Private Wealth Management in Naples, where he serves as a wealth strategist in the National Planning Solutions Group. He received his BBA (accounting) from Florida International University, MST from the University of Miami, J.D. from The University of North Carolina at Chapel Hill, and LL.M. (tax) from the University of Florida College of Law.
The views and conclusions expressed in this article are those of the authors and not necessarily those of Bank of America, N.A., U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A., and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.
This column is submitted on behalf of the Tax Section, Guy E. Whitesman, chair, and Michael D. Miller and Benjamin Jablow, editors.