Just as 2010 may have been the year of the Roth conversion, 2011 may be the year of the Roth recharacterization. After clients visit their accountants and see the tax bill from their Roth conversions, many may get sticker shock and want to undo those conversions.
WORDS OF WARNING
Undoing may not be the best move, however. Before they recharacterize, make sure your clients are aware of the consequences.
* Caution 1: They will lose money. Don't let the tax bill scare your clients off. Even though they owe taxes on the 2010 Roth conversion, the income can be spread over two years (2011 and 2012), which can lessen the amount owed. In addition, tax payments can be deferred for two and three years.
Clients can actually pay less tax and have more time to pay it. That means holding on to their money longer while earning tax-free income in their Roth IRAs.
In addition, 2010 was a pretty good year for most investors, which means tax-free gains have already been locked in. Explain to clients that, if the Roth conversion is undone, these taxfree gains will be transferred back to a traditional (and taxable) IRA.
That only benefits Uncle Sam. Make sure the client sees the long-term big picture and does not let the tax bill overshadow the tax-free income already earned. The client only pays tax on the amount originally converted, even if the Roth IRA account balance is much higher now.
* Caution 2: They will blow the two-year deal. For Roth conversions completed in 2010 only, clients had the choice of spreading the tax due over 2011 and 2012 or paying it when they filed their 2010 taxes. If a 2010 Roth conversion is undone (recharacterized), then the two-year tax deal is lost for good. Even if the same funds are reconverted in 2011, the conversion is now a 2011 conversion and the two-year deal is not available. All of the 2011 Roth conversion income must be reported in 2011.
* Caution 3: They still have time. Even though the 2010 tax return was due on April 18 this year (the extra days were due to a holiday), your client could have filed his or her tax return by the April due date but still have until Oct. 17, 2011, to recharacterize a 2010 Roth conversion. So why rush? Why not take several extra months to see how the Roth investments fare? Maybe the added time will allow clients to reevaluate their decision.
Even if clients filed their returns by April 18, if they take the two-year deal (half the conversion income in 2011 and the other half in 2012), no 2010 Roth conversion income has to be included on the 2010 tax return anyway. If they still want to undo the 2010 conversion, they can always recharacterize up to Oct. 17, 2011, and report the recharacterization on an amended tax return.
* Caution 4: Their required minimum distributions will increase. Once a 2010 Roth conversion is recharacterized, the funds are treated as if they never left the traditional IRA. If the recharacterization is done in the year after the conversion, the Dec. 31 year-end IRA balance reported on the account statements will not be correct. If a client is subject to RMDs, that balance must be increased by the amount of the recharacterization.
For example, assume Joe is 75 and is taking RMDs from his IRA. He'll need to calculate his 2011 RMD, which is based on his Dec. 31, 2010, IRA balance of $500,000. In addition to taking his RMD in 2010, he converted $100,000 to a Roth IRA. In April 2011, he had his 2010 tax return prepared. For whatever reason, he decided to undo his entire 2010 Roth conversion.
Once he recharacterizes and the funds go back to his traditional IRA, his 2011 RMD calculation will change. He must add back the Dec. 31 value of his Roth conversion, which he recharacterized. So his 2011 RMD will be based on both a Dec. 31, 2010, IRA balance of $500,000 and the value of his Roth balance, even though his IRA statement will show a balance of $500,000.
* Caution 5: Clients may not be able to recharacterize the entire conversion. When some people converted in 2010, they did not have money outside of the IRA to pay the tax, so they held back some of the converted funds to pay the tax. That is generally a mistake to avoid at all costs. It is even more of an issue if the client was younger than 591/2 because that would also make any funds not converted subject to the 10% early withdrawal penalty.
But despite these drawbacks and ample warning, some clients held back some of their IRA funds to pay the tax on a Roth conversion anyway. If they now want to undo the conversion, they cannot recharacterize the amount withheld for taxes, so they will owe tax anyway and maybe a 10% penalty on the money not converted.
For example, in 2010, Ann was 45 and wanted to convert $100,000 of her IRA funds to a Roth IRA. She worried that she wouldn't have any cash to pay the tax, so she converted only $80,000 of the $100,000 IRA distribution and held the other $20,000 for taxes.
Now Ann wants to recharacterize the entire $100,000 conversion. But she can't! Ann can only recharacterize the $80,000 actually converted to her Roth IRA. The remaining $20,000 was never converted, so it will still be taxable and subject to a 10% early withdrawal penalty since Ann is younger than 591/2.
Normally, a full Roth recharacterization would eliminate the tax bill on a Roth conversion. This is especially valuable when the account has dropped in value. The recharacterization allows the tax bill to be eliminated so that no tax is paid on value that no longer exists. But in this example, Ann will still owe some tax on her conversion even if she recharacterizes. She cannot remove the full tax liability because not all of the IRA distribution was converted.
* Caution 6: Make sure the right amount is recharacterized. The biggest caution is making sure the right amount is recharacterized. A recharacterization means that funds in the Roth are transferred back to a traditional IRA. But how much gets transferred? If there was only one Roth conversion to one new Roth account and the entire conversion is recharacterized, that's easy. The entire Roth IRA balance, whatever it is, gets transferred back to the client's traditional IRA and the tax bill on the conversion is eliminated.
But what if your client wants only a partial recharacterization? Even for CPAs, this calculation can be a nightmare, especially if the money was converted to an existing Roth IRA that included funds from prior year conversions or contributions. A recharacterization includes net income attributable to the amount being recharacterized.
For example, assume Phil converted $100,000 to a new Roth IRA in 2010. No other additions or subtractions to the account were made, and his balance has now dropped to $60,000. Obviously, Phil should recharacterize his conversion if he doesn't want to end up paying tax on lost value. Since Phil is going to make a full recharacterization, the entire $60,000 will be moved back to a traditional IRA as the net amount of his $100,000 conversion.
But what amount should Phil ask the custodian to recharacterize? Should it be $60,000? Absolutely not. Remember, the recharacterization is how much of the original tax bill you are trying to wipe out. If Phil only requests a $60,000 recharacterization, he will still owe tax on $40,000.
Instead, a full recharacterization is made by using the full value of the original conversion, which in this case was $100,000. Phil recharacterizes the full amount and his entire tax on the Roth conversion is eliminated. But the actual amount of funds transferred back to his IRA is only the $60,000, which represents what's left of his converted funds.
Here's another example. Assume Buddy converted $100,000 to a new Roth IRA in 2010. No other additions or subtractions to the account were made and, through some shrewd investing, his balance has grown to $180,000. Although Buddy would like to keep everything in a Roth IRA because of the tax-free gains, he realizes that he doesn't have enough money to pay the full tax bill and can only afford to pay tax on a conversion of $60,000. Buddy must therefore recharacterize $40,000 of his initial conversion ($100,000 -$40,000 = $60,000).
Buddy cannot simply transfer back $40,000 to a traditional IRA, though; he has to take into consideration the gains while that money was in the Roth. So in this case, since 40% of the conversion is being reversed, 40% of the gains must go back as well. Therefore, the amount transferred back to Buddy's traditional IRA for his $40,000 recharacterization is $72,000 ($180,000 x 40% = $72,000).
These examples are far easier than they could have been since in both cases the conversions were made to new Roth IRAs and no other additions or subtractions were made prior to the recharacterization. When this is not the case, however, a more complex net income calculation is required. IRS Publication 590 has information on how to calculate the total.
Your clients may be in a rush to recharacterize their 2010 Roth conversions when they see their tax bills, but the best advice you likely can give them is to slow down and take a thorough look at the pros and cons of recharacterization before making the move.
Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books. He has also created programs to help financial advisors become recognized leaders in the IRA marketplace. Visit his website at www.irahelp.com.