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by Denise Appleby CISP, CRC, CRPS, CRSP, APA |
Important Update: The Tax Cuts and Jobs Act of 2017 repealed the option to recharacterize Roth conversions, for Roth conversions done after 2017. As such, only regular contributions to traditional IRAs and Roth IRAs may now be recharacterized.
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As a result of the recent roller coaster like activity in the securities market, many individuals have seen their portfolios lose significant market value over a relatively short period. For individuals who converted amounts to Roth IRAs, this is even more disconcerting because they may now owe income taxes on amounts they no longer have in their retirement accounts. So what is a taxpayer to do when he[1] has a tax bill for a Roth IRA conversion which is greater than the current value? There is good news; a recharacterization can make that tax bill disappear!
Taxation of Roth Conversions
Roth conversion amounts are treated as ordinary income for the year that the conversion occurs. This means that individuals who completed Roth IRA conversions last year were required to include any taxable amount of the conversion on the tax returns they filed for last year. For those who completed Roth IRA conversions this year, the taxable income from the conversion must be included on the tax return they will file for this year. See Reporting and Paying The Income Tax on a 2010 Roth Conversion for an exception to this rule
Nullifying a Roth Conversion
The tax bill from a Roth conversion can be voided by recharacterizing the conversion. However, the recharacterization must meet certain specific requirements to be considered valid. These are as follows:
- The conversion must be completed by the individual’s tax filing deadline, including any extensions. Individuals who file their tax return or file for an extension by the due date receive an automatic six-month extension for completing the recharacterization. For individuals who file on a calendar year, this six-month extension ends October 15. This means that individuals who completed Roth conversions last year have until October 15 of this year to recharacterize that conversion[2]. See Deadline for Recharacterization Extended by the IRS- Financial Institution’s Error for an example of when the IRS extends this deadline beyond October 15.
- The recharacterization must be accompanied by any net income attributable (NIA) to the conversion.
The end result is that the recharacterized amount is treated as if it was never converted for tax purposes, and therefore not included in the individual’s income for tax purposes.
Computing the NIA
If the Roth IRA from which the recharacterization is being done holds only the conversion which is being recharacterized (plus any earnings or minus any losses), there is no need to compute the NIA, as recharacterizing the entire balance will suffice. The NIA is required to be computed only under the following circumstances:
- Less than 100% of the conversion is being recharacterized.
- The Roth IRA includes funding from other transactions such as a Roth IRA contribution, another Roth IRA conversion from another year or even the same year, or a transfer from another Roth IRA
While computing the NIA is not a complex process, it can be somewhat troublesome, especially if the financial institution which has custody of the Roth IRA does not provide such services. Individuals who need to calculate NIA can refer to IRS publication 590 (at www.irs.gov) for instructions.
Tip:It is practical to keep a conversion amount in a separate Roth IRA until the deadline for recharacterization has passed. This might eliminate the need to perform any NIA calculations.
Reasons for Recharacterizing a Conversion
An individual can recharacterize a Roth IRA conversion for reasons which include the following:
- The individual simply wants to. No particular reason is needed. The individual can simply feel like he no longer wants to have a conversion done for that year, in order to recharacterize the conversion.
- The individual is unable to pay the taxes owed on the conversion
- The conversion will put the individual into a higher tax bracket, resulting in other income- as well as the Roth conversion amount- being taxed at a higher rate
- The conversion will result in the individual being subject to alternative minimum tax
- The conversion will result trigger a surcharge for his Medicare Part B coverage
- The conversion was invalid or was a failed-conversion.
- The conversion amount has lost market value, and the individual does not want to pay a tax bill for a conversion value that he no longer has
- The individual is ineligible for the conversion because his modified adjusted gross income (MAGI) is more than $100,000 and/or his tax filing status is married-filing separately ( Note: This restriction was repealed effective 2010, and included just to be thorough).
It’s Not All or Nothing…
A recharacterization need not be for the entire conversion amount. Instead, an individual can choose to recharacterize a partial amount of the conversion. When doing a partial recharacterization, the conversion amount used in computing the NIA is determined as of the date the conversion occurred. For instance, if the individual converted $100,000, and wants to recharacterize $80,000, the NIA should be computed on $80,000 even if the market value of the conversion has fallen below $80,000.
Individuals who recharacterize partial conversion amounts may need to file IRS Form 8606.
Reconverting the Recharacterized-Conversion
The IRA owner can reconvert the recharacterized amount or a percentage thereof at a later date after the recharacterization. However, caution must be exercised here as there are time limitations on when this can be done. Under these time limitations, a reconversion cannot occur before the later of:
- The beginning of the taxable year following the taxable year in which the amount was converted to a Roth IRA ,or
- The end of the 30-day period beginning on the day on which the recharacterization occurs
A reconversion that occurs before the later of these two dates is not a valid conversion.
Conclusion
Individuals who did conversions to Roth IRAs should check the Roth IRA to determine if the amount has lost market value and determine whether they want to recharacterize the amount. The financial institution should be contacted in advance of the recharacterization deadline in order to determine if they will calculate the NIA. If not, the calculation should be done otherwise and the NIA included in the amount which the financial institution is instructed to recharacterize. It is of paramount importance that the request is submitted to the financial institution before the recharacterization deadline, in order to prevent the IRA owner from being stuck with a tax-bill for a transaction from which no financial benefit was received.
