Reconsidering 2010 Roth IRA Conversions
September 13, 2011
By Magda Szabo, CPA, LL.M.
Given recent market volatility, the decision to complete a Roth conversion from last year and pay the taxes owed may be difficult for some taxpayers. Taxpayers should be aware not only of the costs and benefits of converting but also of options and limitations in reconsidering or recharacterizing" IRA Roth conversions. The latter is a viable option, especially for taxpayers adversely impacted by current market conditions that have materially decreased the value of the converted account, or who are otherwise reconsidering a prior Roth IRA conversion.
Roth IRAs date back to 1997 and were established as an alternative tax-deferred investment vehicle to traditional IRAs and pension plans. In contrast to traditional IRAs or pension plans where the tax liability is back-loaded, the tax liability for Roth IRAs is front-loaded. That is, instead of contributing pre-tax 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, uniquely, tax-free distributions.
Roth IRAs are favored over traditional IRAs by estate and financial planners for numerous reasons including: (1) assuming even a modest amount of investment growth, the overall tax liability is appreciably lower; (2) traditional IRAs are subject to minimum required distributions in the year the taxpayer reaches age 70.5 whereas Roth IRAs are not; and (3) Roth and traditional IRAs are generally valued the same 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.
While Roth and traditional IRAs are subject to the same annual contribution limitations ($5,000 for single taxpayers, $6,000 if over 50), Roth IRAs are restricted to annual earned income levels of $167,000 (phasing out at $177,000) for married taxpayers filing jointly only and $105,000 (phasing out at $120,000) for single taxpayers. In 2006, the Roth" concept was expanded to employee elective deferrals under 401(k) Cash or Deferred Arrangements. Where such 401(k) plans have been amended to allow for elective Roth contributions, the annual deferral limitations are much higher: $16,500 ($ 22,500 for those aged 50 or older).
Starting in 2010, legislation further expanded the scope of Roth IRA deferrals, allowing conversions from traditional IRAs and certain pension plans to Roth IRAs without limitation as to income levels or filing status. In addition, taxable income created by a conversion in 2010 can be recognized across a delayed two-year period commencing in 2011. Specifically, conversions from traditional IRAs, SEPs, or SIMPLE IRAs (if held for at least two years) can be achieved by one of three methods: (1) a distribution from a traditional IRA that is rolled over into a Roth 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 2010, a significant number of taxpayers apprised of the income and estate tax planning opportunities generated by Roth IRA conversions elected to convert eligible funds to a Roth IRA, thereby incurring an appreciable income tax liability to be paid pro rata over the following two years. Since 2011 is the first such year that 50% of the tax liability is actually owed, some taxpayers who elected conversion in 2010 and have since experienced adverse market or financial conditions or who may be having second thoughts when faced with the reality of payment may be seeking to undo some or all of the conversion. For such taxpayers, limited relief is available in the form of a recharacterization" of the original conversion" to an eligible rollover."
Such a step should be made only after careful consideration and caution, especially because failure to adhere strictly to the rules can result in a deemed taxable distribution of the funds involved, triggering not only income taxes on the distribution but also 10% excise (penalty) taxes plus interest on unpaid taxes.
There are a number of requirements for recharacterization. A trustee-to-trustee transfer of the funds the taxpayer no longer wishes to convert must be completed no later than the due date for the 2010 tax return (including the six-month extension), or specifically October 17, 2011. It does not matter whether the tax return for 2010 was already filed, as long as the actual transfer is completed by October 17th and the original 2010 tax return is timely filed. If the recharacterization is effectuated after the return has already been filed, an amended return will need to be filed. A statement explaining the reversal must be attached to the return (or amended return).
Eligible transfers include those involving the same trustee as well as custodial and account transfers. However, the amount of the transfer must be adjusted for any income or loss allocable to the funds that are not being converted (recharacterized). In addition, no deduction or adjustment could have been involved in the original conversion; the funds cannot be traceable to a Roth IRA; and the trustees of the IRAs involved must be informed. The recharacterization will spawn a number of filings including Form 1099-R, Form 5498 detailing the amounts and earnings, and Form 8606.
Lets look at a simple example. Assume Taxpayer Smith made a qualified rollover contribution converting his traditional IRA to a Roth IRA of $100,000 in 2010. Assume that the earnings on this $100,000 from the time of the conversion to the time of recharacterization are $20,000. Due to market declines, Taxpayer Smith does not have enough to cover the entire associated tax bill, so he decides to undo half of this conversion. 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 to a traditional IRA in a trustee-to-trustee transfer.
Once a Roth recharacterization is completed, the funds are treated as if they never left the traditional IRA or, if they came from a company pension plan, as if they were directly rolled over to a traditional IRA. If a client is over age 70.5, the amount will also increase the total from which required minimum distributions must be calculated. This calculation is critical, because where there is a failure to distribute the appropriate required minimum amount from a pension plan or traditional IRA, a 50% excise tax penalty in the amount of the undistributed amount is imposed.
Lets look at an example involving minimum required distributions and a recharacterization. Taxpayer Jones is 80 years old and has a traditional IRA with a balance of one million dollars. After taking a minimum required distribution in 2010, he converts 50% of his IRA to a Roth. Due to recent market losses, he realizes in 2011 that he may need to withdraw funds from this converted Roth IRA in the next five years for personal living expenses, and 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 required minimum distribution for 2011 must be calculated taking into account the combination of all these amounts: $1,000,000 original and reconstituted IRA total, plus the increase in value by year-end of $30,000 or a total of $1,030,000.
One of the most valuable applications of the recharacterization rules occurs where the underlying IRA has dropped in value due to market losses subsequent to conversion resulting in an income tax liability being calculated and owed by a taxpayer on higher values that have disappeared. In such situations, taxpayers can rescind the conversion entirely by a recharacterization and thereby 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 again re-convert e.g., a traditional IRA to a Roth IRA until the later of (1) the beginning of the tax year following the original Roth conversion or (2) the end of the 30-day period beginning with the day the Roth conversion was recharacterized.
For example, lets assume Taxpayer Jones (Jones") elected in 2010 to convert 50% of his $200,000 traditional IRA into a Roth. On April 15th, 2011 Jones extends the time for filing his 2010 return. However, due to market conditions, as of June 30th Jones $100,000 converted IRA balance has dropped in value to $85,000. To avoid paying income taxes on the full value of the IRA, or $100,000, Jones can recharacterize and rescind the 2010 conversion June 30th, 2011 by making a trustee-trustee transfer (including profit/loss amounts netting to $85,000) and filing the appropriate information with his tax return. This results in the original $100,000 conversion being treated as if never occurred. Thirty days later, or on July 30th, Jones can again elect to convert this lower amount of $85,000 to a Roth IRA and thereby complete a Roth IRA conversion at a tax liability that is adjusted for the drop in value of the IRA. Once this done, Jones cannot recharacterize again until the following year, 2012, if the value of his IRA continues to drop. The recharacterization option should be weighed against the loss of the two-year deferral that is otherwise allowed for a 2010 conversion. Nevertheless, where the market drop is substantial enough, a recharacterization does make 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 should be aware and understand this option prior to finalizing their Roth IRA conversions.