By Denise Appleby,CISP, CRC, CRPS, CRSP, APA
There is a long-held belief in the IRA industry, that one is not permitted to cherry pick stocks or other assets when recharacterizing a Roth conversion or IRA contribution. But it can be done through application of a simple algebraic formula, which negates the need to maintain multiple Roth IRAs for Roth Conversions.
An IRA owner who wants to change a regular traditional IRA contribution to a regular Roth IRA (or vice versa) may do so by recharacterizing that contribution. The recharacterization process also allows an individual to reverse amounts that were converted from traditional retirement accounts (employer sponsored retirement plans and IRAs) to Roth IRAs, thereby nullifying the tax impact of the conversion.
Important Tax Law Change: In accordance with the Tax Cuts and Jobs Act (Pub. L. No. 115-97), Roth Conversions done after 2017 cannot be recharacterized. However, regular IRA contributions can still be recharacterized.
A recharacterization must be completed by the IRA owner’s tax filing due date, plus extension. And, one who files one’s tax return by the due date, receives an automatic 6-month extension to complete one’s recharacterization.
One can choose to recharacterize a full or partial contribution or conversion. When performing a recharacterization of less than the full account balance, the IRA owner can choose to cherry pick which assets to recharacterize. Cherry picking is a useful option when one wants to choose whether to recharacterize only certain assets- such as those that have lost market value.
Why Some Believe Cherry Picking is Impermissible
Cherry picking would matter only if one recharacterizes less than the full account balance. Such would be the case, if one performs:
·a ‘partial recharacterization’ of a contribution or Roth conversion; or
·a full recharacterization of a contribution or conversion from an account that had other funding activities (other contributions, conversions, rollovers, transfers, distributions, conversions, recharacterizations).
For the purpose of this article, the term ‘partial recharacterization’ is used for both scenarios.
When performing a partial recharacterization, any net income attributable (NIA) to that contribution or conversion must be included. When calculating the NIA, the performance of all assets held in the IRA, during the computation period, must be factored into the equation.
Example: If an IRA owner converted 10 different securities to a Roth IRA and wants to recharacterize only one of those securities; the NIA calculation must factor the performance of all ten securities plus any other assets that were held in the Roth IRA during the computation period (defined below).
It is because of this requirement why many believe that it is not permissible to cherry pick assets for the recharacterization process. However, as is demonstrated below, it can be done by what some might consider ‘reverse engineering’ the NIA formula.
Note: The NIA can be earnings or losses.
The Problems that Cherry Picking Solves
Because of the long-held belief that cherry picking was not permissible for recharacterizations, industry experts often advise IRA owners to convert different assets to separate Roth IRAs. This would allow one to simply recharacterize a full Roth IRA balance for assets that one no longer wants to keep in one’s Roth IRA.
Example: Mavis has a Roth IRA (let’s call it Roth IRA #1) that she started several years ago. Roth IRA #1 has a balance of $500,000, which consists of a mixture of different assets.
Mavis wants to do a Roth IRA conversion of 100 shares of Stock A, from her traditional IRA.
Knowing that Mavis can recharacterize any portion of the conversion for any reason- which is especially important if Stock A loses market value- her advisor instructs her to convert the 100 shares of Stock A to a new Roth IRA (let’s call it Roth IRA #2) that holds no other assets.
If the market value of Stock A falls, Mavis can simply recharacterize the full balance of Roth IRA #2, which would– by default- include the NIA.
Note: In such a case, Mavis would likely be advised to combine both Roth IRAs, after the deadline for recharacterization has passed.
While this strategy can be practical, it could be less so if it becomes necessary to establish multiple Roth IRAs. Which could be the case if Mary wanted to convert 100 different securities or different asset classes to different Roth IRAs.
The ability to cherry pick solves this issue.
Consider too, that if Mavis had already converted the 100 shares of Stock A to Roth IRA #1, she can still recharacterize the 100 shares and have the same tax impact as if the shares were converted to Roth IRA# 2.
The Net Income Attributable Formula
As noted earlier, any recharacterization must include the NIA for the recharacterized amount.
A specific formula must be used to determine the NIA. But that is necessary only in certain cases.
No Application of NIA Formula Needed for Recharacterization of full balance
If an individual recharacterizes the full balance of an account, then no calculation is required. This is because moving the full account balance in effect incudes the NIA.
Example: John makes a regular traditional IRA contribution of $5,500 to a new traditional IRA. The traditional IRA has no other funding activity.
John wants to recharacterize the full contribution to his Roth IRA.
At the time of recharacterization, the account had earnings of $500, bringing the total traditional IRA balance to $6,000.
To make the contribution a Roth IRA contribution, John would instruct his IRA custodian to recharacterize the entire $6,000 to his Roth IRA.
Caution: John must meet certain modified adjusted gross income (MAGI) requirement,to be eligible for the Roth IRA.
Application NIA Formula Required for Recharacterization of less than full balance
If less than the full account balance is being recharacterized, then the NIA formula must be applied to determine how much should be included in the recharacterization.
Less than the full account balance would be recharacterized under either of the following circumstances:
·Partial Recharacterization of a Regular IRA Contribution
Example: John makes a regular traditional IRA contribution of $5,500. John wants to recharacterize only $2,500 of the $5,500.
·Partial Recharacterization of a Roth IRA Conversion
Example: Suzie converts $100,000 from her traditional IRA to her Roth IRA. Suzie wants to recharacterize only $40,000 of the $100,000.
·Full Recharacterization from Account with Other Funding Activity
Example: Mary converts $100,000 from her traditional IRA to her Roth IRA. The Roth IRA holds assets from contributions and other conversions.
Mary wants to recharacterize the full $100,000.Even though this is a full recharacterization of the hundred thousand dollars, the NIA formula must still be used to determine the NIA to the hundred thousand dollars.
The following is the NIA formula, as provided under Treas. Reg. 1.408-11.
|
Contribution or conversion amount being recharacterized |
X |
(Adjusted closing balance- adjusted opening balance) |
= |
NIA |
|
Adjusted opening balance |
The following are terminologies one must understand, when applying this formula:
·Adjusted opening balance. This is:
oThe FMV of the Roth IRA that holds the contribution or conversion amount that is being recharacterized, at the beginning of the computation period; plus
oAny contributions or Roth conversions (including the amount being recharacterized), transfers, and recharacterizations made to the IRA during the computation period.
·Adjusted closing balance. This is:
oTheFMV of the Roth IRA at the end of the computation period; plus
oAny distributions, transfers, or recharacterizations made from the IRA during the computation period.
·Computation period. This is the period beginning immediately prior to the time that the contribution or conversion (that is being recharacterized) was made to the Roth IRA and ending immediately prior to the recharacterization of the amount.
Example: Sue converted $32,000 to her Roth IRA on June 1, 2017 when it had a FMV of $96,000.
Sue met with her tax advisor, who determined that converting only $24,000 would be most tax efficient; and advised her to recharacterize $8,000 ($32,000-$24,000).
Sue contacted her IRA custodian on March 1, 2018 and instructed them to recharacterize the $8,000. At that time, her Roth IRA had a FMV of $152,000.
During the computation period, no other funding (contributions etc.) were made to the Roth IRA and no distributions or other debit related activity were made from the Roth IRA.
The custodian applies the NIA formula to determine how much to include in the recharacterization, as follows:
The adjusted opening balance is $128,000 [$96,000 + $32,000]
The adjusted closing balance is $152,000.
[$8,000 × ($152,000−$128,000) ÷ $128,000] = $1,500.
The NIA to the $8,000 March 1, 2018 contribution is $1,500.
To recharacterize the $8,000, the NIA of $1,500 must be included. The total recharacterized amount would then be $9,500 ($8,000 + $1,500).
Cherry Picking Assets for Recharacterization
The cherry picking strategy is likely to be used to recharacterize assets that have lost market value. In such cases, the objective would be to determine the NIA attributable to the losers.
Examples of Cherry Picking Assets for Recharacterization
Example 1: Conversion done to Roth IRA that held assets other than the converted amount
Assume that we have the same scenario above with Sue. Except that she only wants to recharacterize the stock that lost market value.
Assume too, that when she converted the $32,000, it comprised of:
·100 shares of Stock A, valued at $16,000 and
·100 shares of Stock B, valued at $16,000
And, when she requested the recharacterization, the value of the assets is a total of $38,000, broken down as follows:
·100 shares of Stock A, valued at $28,500 and
·100 shares of Stock B, valued at $9,500
Sue wants to recharacterize only Stock B. The following steps should be taken, to accomplish her objective.
Step 1: Determine the NIA of the total amount converted
The first step would be to determine the NIA on the full $32,000
The adjusted opening balance would be: $128,000 [$96,000 + $32,000]
The adjusted closing balance would be $152,000.
[$32,000 × ($152,000−$128,000) ÷ $128,000] = $6,000
The NIA to the $32,000 would be $6,000
Total value, along with NIA as of March 1, 2018 would be $38,000 ($32,000 + $6,000)
Step 2: Determine the percentage by which the full conversion amount ($32,000) has grown
NIA (growth) = $6,000
6000/32000 = 0.1875.
The $32,000 has grown at a rate of 18.75%
Step 3: Determine the NIA of the stock to be recharacterized
While the overall growth is 18.75%, Stock B performed poorly.
Sue must now determine how much of the $9,500 (the current FMV of Stock B) is NIA.
The solution is to solve for X; when X, X+.1875 X = $9,500.
X + 0.1875X = 9,500
X = 9,500/1.1875
X = 8,000
NIA is $1,500 (9,500 – 8,000)
Note: In this case, Sue must notify the IRA custodian of the NIA amount.
To cherry pick Stock B, Sue would:
Instruct the IRA custodian to recharacterize 100 shares of Stock B
The current market value of stock B would be $9,500.
The custodian’s recharacterization form might have a section to input the NIA. Sue should add a note to the form, explaining the that conversion of the 100 shares represents a recharacterization of $8,000, plus the NIA of $1,500.
This would be sufficient, as the processing and reporting done by the custodian does not make a distinction between the original market value of the conversion and the NIA. Instead, the amount is lumped into one total for reporting purposes.
The result: Sue cherry picked Stock B for her recharacterization.
Sue must provide the breakdown to her tax preparer ($8,000 plus NIA of $1,500), as it would be required for tax filing purposes.
Proof: If Sue had converted Stock B to a separate Roth IRA, the result- recharacterizing the full balance of that account (100 shares now valued at $9,500)- would be the same.
Let’s look at another example
Example 2: Conversion done to Roth IRA, where the Roth Conversion is the only activity
Bill converted $100,000 to his Roth IRA. This comprised of:
·100 shares of Stock A, valued at $30,000
·100 shares of Stock B, valued at $45,000 and
·100 shares of Stock C, valued at $25,000
A few months later, the value of the assets totaled $125,000. The breakdown is:
·100 shares of Stock A, valued at $45,000
·100 shares of Stock B, valued at $65,000 and
·100 shares of Stock C, valued at $15,000
Bill wants to recharacterize only the 100 shares of Stock C
Step 1: Determine the NIA of the total amount converted
The first step would be to determine how much the $100,000 has grown.
Since there were no other deposits (contributions, rollovers, conversions etc.) to, or distributions etc. from the Roth IRA- it’s easy to see that the NIA is $25,000 ($125,000- $100,000).
Step 2: Determine the percentage by which the full conversion amount has grown
NIA (growth) = $25,000
25,000/100,000 = 0.25
The $100,000 has grown at a rate of 25%
Step 3: Determine the NIA of the stock to be recharacterized
While the overall growth is 25%, Stock C has lost market value.
Bill must now determine how much of the $15,000 (the current FMV of Stock C) is NIA.
The solution is to solve for X, when X, X +.25 X = $15,000.
X + 0.25 X = 15,000
X = 15,000/1.25
X = 12,000
The NIA is $3,000 ($15,000 -$12,000)
To cherry pick Stock C, Bill would:
Instruct the IRA custodian to recharacterize 100 shares of Stock C
The current market value of stock C would be $15,000.
The custodian’s recharacterization form might have a section to input the NIA. Bill should add a note to the form, explaining the that conversion of the 100 shares represents a recharacterization of $12,000, plus the NIA of $3,000.
The result: Bill cherry picked Stock C for his recharacterization.
Proof: If Bill had converted Stock C to a separate Roth IRA, the result- recharacterizing the full balance of that account (100 Shares now valued at $15,000)- , would be the same.
Bill must provide the breakdown to his tax preparer ($12,000 plus NIA of $3,000), as it would be required for tax filing purposes.
You Might Be on Your Own with NIA Calculations
Not all IRA Custodians will calculate NIA amounts. And, it is unlikely that any will perform the calculation when the recharacterization involves cherry picking. In such cases, converting assets to separate Roth IRAs can be practical if there are no compelling reasons to maintain one Roth IRA- such as converting fifty different securities, in which case, converting to fifty different Roth IRAs would be impractical.
Trading Could Impact Cherry Picking
Cherry picking works if the converted assets are still in the Roth IRA at the time of recharacterization. If those assets have been liquidated, then the formula does not apply.
Compliance Counts
This technical explanation is only part of the recharacterization process. Others include meeting the IRA custodian’s operational and documentation requirements, and the IRS’s tax reporting requirements.
Interested parties should coordinate the entire process, to ensure that all compliance requirements are met.
Originally published in The IRA Authority- March 2018 ( www.irspublications.com)
