What if your client converted his or her traditional IRA to a Roth IRA just before the financial markets pulled back, and now your client is questioning the decision to convert? What if your client only wants to reverse part of the conversion involving investments that performed poorly? This blog might help you plan for these client concerns.
Taxpayers may want to convert from a traditional IRA to a Roth IRA because the long-term tax savings on income-tax-free qualified distributions from a Roth IRA in the future may outweigh any conversion tax incurred today. For more information on Roth IRA Conversions and when they may make sense for your clients, see Year-End Planning Idea – Roth IRA Conversion by Steve Chmelka.
Although a Roth IRA conversion could make sense one day, the original impetus and rationale for the transaction may be questioned at a later date when the conversion is followed by, for example, a market correction – resulting in a lower account value even though your client paid income tax on a higher pre-conversion account value. Clients in this situation may be looking to reverse (also called "recharacterize") the conversion by meeting all necessary requirements prior to the recharacterization deadline. Practically speaking, this generally means notifying the IRA provider(s) that the client has elected to treat the conversion as never having been converted to a Roth IRA, and the recharacterization must be processed before the respective deadline.
|Client Situation||Deadline to Recharacterize|
|Converted traditional IRA to a Roth IRA during the 2013 calendar year||Tax filing due date plus extension (i.e., by October 15, 2014)|
|Converted traditional IRA to a Roth IRA during the 2014 calendar year||Tax filing due date plus extension (i.e., by October 15, 2015)|
Sharon, age 60, converted $100,000 of traditional IRA account value to a newly established Roth IRA account on February 1, 2014. Within the Roth IRA account, she purchases two types of investments: (1) $50,000 of small-cap mutual funds, and (2) $50,000 of currency strategies mutual funds.
In March 2015, a little over a year later, her small-cap mutual funds dropped in value, and she reaches out to a tax advisor about recharacterizing these poorly performing funds (now worth $40,000) back to a traditional IRA so she can recover the income tax she paid on $50,000 at the time of the conversion (when she initially purchased the small-cap mutual funds). Sharon also wants to leave the currency strategies mutual funds (and their associated gains) alone in the same Roth IRA where the value of these funds has grown to $70,000. Sharon’s trying to preserve any gains in the Roth IRA account so she can later distribute them as an income-tax-free qualified distribution in retirement.
Unfortunately, IRS rules require that Sharon specify the dollar amount she's recharacterizing (not the asset itself), and that she also transfer back to the traditional IRA a pro rata portion of all earnings (known as "net income") on the dollar amount recharacterized to the traditional IRA. Sharon wants to recharacterize $50,000 because she wants to avoid the tax she paid on $50,000. The net income allocable to the $50,000 she's trying to recharacterize ends up requiring that she transfer an additional $5,000 [$50,000 x ($110,000 – $100,000)/$100,000] in order to recharacterize $50,000 (Treas. Reg. Sec. 1.408A-5, Q&A2). In other words, to recharacterize $50,000 (and avoid tax on $50,000), she would need to transfer assets from the Roth IRA to the traditional IRA totaling $55,000 [$50,000 + $5,000] by October 15, 2015. Although Sharon was able to reduce her 2014 tax bill by more than half as a result of the recharacterization of $50,000, she was disappointed that she had to move $5,000 of gain from the successful investment over to the traditional IRA as well (effectively subjecting the gain to ordinary income whenever she distributes it to herself in retirement).
Let's now imagine that Sharon had consulted a tax advisor prior to the conversion decision. Knowing that Sharon wants to put the converted assets in two different investments, the tax advisor suggests she convert the single traditional IRA into two newly created Roth IRA accounts that each hold the respective investments. Thus, Shannon converts the entire account to two Roth IRAs on February 1, 2014, sending $50,000 to each account. Again, the mutual funds in one Roth IRA are solely small-cap mutual funds worth $50,000, and the other Roth IRA holds currency strategies mutual funds worth $50,000.
During the next year, in March 2015, Sharon is upset with the performance of the Roth IRA holding small-cap mutual funds, and she wants to reverse the transaction. She also wants to leave alone the Roth IRA holding the currency strategies mutual funds worth $70,000.
Fortunately, by creating two separate Roth IRA accounts, Sharon is able to leave the $70,000 Roth IRA alone, and can recharacterize $50,000 by moving the entire Roth IRA with a $40,000 balance to the traditional IRA. Thus, Sharon can recover the 2014 taxes paid on the Roth IRA conversion that has declined in value (from $50,000 to $40,000) by moving the balance back to her traditional IRA. Sharon needs to complete the recharacterization by October 15, 2015.
In summary, with this strategy, Sharon can keep the account holding the outperforming mutual funds (with associated gains) in her remaining Roth IRA and, at the same time, recover all the tax she paid on the other Roth IRA account conversion that performed poorly.
For more general information on Roth IRA conversions and/or recharacterization, please feel free to contact Retirement Strategies Group at (800)722-2333, ext. 3939, or e-mail us at RSG@PacificLife.com.
Calculator: "Should I Convert to a Roth IRA?"
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