Author: Tim Steffen, CPA/PFS, CFP®, CPWA®, is the director of financial planning at Robert Baird & Co.
A taxpayer should consider recharacterizing contributions made to a Roth IRA if doing so will reduce overall tax liabilities.
Pursuant to Section 408A(b), a Roth IRA is an individual retirement plan (as defined by Section 7701(a)(37)) that is designated at the time of the establishment of the plan as a Roth IRA. Roth IRAs are treated like traditional IRAs except when the Code specifies different treatment. As a result, there are several significant differences between Roth IRAs and traditional IRAs. For example, eligibility to contribute to a Roth IRA is subject to special modified AGI limits, and Roth IRA contributions are never deductible. Further, qualified distributions from a Roth IRA are not includable in gross income; the Sections 408(a)(6) and (b)(3) minimum distribution rules do not apply to the IRA during the owner’s lifetime; and contributions can be made after the owner has reached 70 1/2.
A Roth recharacterization is the process of unwinding a Roth contribution, conversion, or rollover. Recharacterization provides the taxpayer with the ability to fine tune the conversion amount, in part or whole, long after the initial conversion has been completed.
Under Reg. 1.408A-5, taxpayers can recharacterize a conversion from a traditional IRA or a rollover from a qualified retirement plan by making a trustee-to-trustee transfer from the Roth IRA to a traditional IRA. Rollovers from a qualified retirement plan must be recharacterized to a traditional IRA, not back to the original qualified retirement plan. In addition, recharacterizations are not available for Roth conversions from a traditional qualified retirement plan to a Roth qualified retirement plan, known as “in plan conversions.”
Recharacterization Period for a Roth Conversion
The recharacterization period starts on the day of the initial conversion and is open through the due date of the tax return for that year, plus extensions-typically October 15th of the year following the year of conversion. After a Roth conversion has been recharacterized to a traditional IRA, the taxpayer may reconvert those same dollars back to a Roth IRA after waiting the applicable period. The taxpayer must wait until the later of: (1) January 1 of the year following the year of the original Roth conversion, or (2) 30 days after the recharacterization date (See Exhibit 1).
Exhibit 1: Recharacterization period
However, a taxpayer is allowed to convert other assets within an IRA to a Roth IRA, without having to satisfy the waiting period. For example, a taxpayer converts $100,000 from a traditional IRA to a Roth IRA in May when the traditional IRA was valued at $400,000. In October, the taxpayer recharacterizes the entire conversion amount back to the traditional IRA. The recharacterized amount ($100,000) is not eligible to be reconverted to a Roth IRA until January 1st of the following year. Any portion of the additional $300,000 in the traditional IRA could be converted to a Roth IRA immediately.
Reasons for Recharacterization
Taxpayers are not required to provide the IRS with a reason for recharacterizing. However, there are several reasons why a taxpayer may be likely to recharacterize.
The most common reason for recharacterizing a Roth conversion is that the converted amount has declined in value since the conversion was completed. For example, a taxpayer converts an IRA worth $100,000 to a Roth IRA. In the following months, the new Roth IRA declines in value to $70,000. The taxpayer may decide that he or she does not want to pay tax on the $100,000 conversion while having only $70,000 in the Roth IRA. The taxpayer may choose to recharacterize the $70,000 in the Roth IRA back to the traditional IRA, wait the applicable period, and then reconvert the traditional IRA to a Roth IRA. As long as the value of the traditional IRA does not increase to more than $100,000 before reconverting, the taxpayer may reduce his or her overall tax cost.
Another reason for recharacterization is that the taxpayer may realize that an event has occurred that causes him or her to be unable or unwilling to pay the income tax liability created by the conversion. For example:
- The taxpayer’s other income was higher than expected, resulting in greater than anticipated federal or state income taxes.
- The taxpayer unexpectedly became subject to alternative minimum tax, thus increasing the overall tax cost of the conversion.
- The income from the conversion triggered a loss of other deductions or credits, thereby increasing the tax cost of the conversion.
The additional income from the conversion may cause an increase in Medicare premiums. Medicare participants with modified AGI over $170,000 ($85,000 if single) are subject to higher premiums for Medicare Part B, even if that increase is due to a Roth conversion. There is a two-year delay in the premium adjustment, meaning that 2014 income is used to determine 2016 Medicare premiums.
Not all states tax distributions from retirement plans the same. If the IRA owner is planning a move to a state with a lower tax rate, or one that excludes IRA income from taxation, a Roth conversion may result in a higher tax cost than leaving the traditional IRA as it is.
For example, a taxpayer moves from Wisconsin to Florida in the year following a conversion. The taxpayer will be subject to Wisconsin income taxes for the conversion amount. However, if the taxpayer had waited to engage in the conversion until the move to Florida, which has no state income tax, the total tax cost on the conversion would have been lower.
If the taxpayer’s tax filing status is likely to change, it may provide an opportunity to reduce taxes by deferring the conversion to the year of the change. For example, a taxpayer who is engaged to be married the year following a conversion may discover that the married filing jointly tax bracket results in a lower tax liability on the conversion than the single bracket.
If the beneficiary of the traditional IRA is expected to have a lower tax rate than the IRA owner, the total taxes paid by the beneficiary on the future withdrawals may be less than what the IRA owner has to pay today to convert.
For example, the taxpayer names his child as the beneficiary of the traditional IRA. The parent then converts that IRA to a Roth IRA while in a high tax bracket. If the child is projected to be in a lower tax bracket during her lifetime, her tax on the future IRA withdrawals may be less than what the parent would pay to convert. In this case, recharacterizing and leaving the money in the IRA may be appropriate.
For taxpayers who have made nondeductible contributions to a traditional IRA, a prorated portion of that IRA can be converted to a Roth IRA tax-free. However, assume that the taxpayer also has a qualified plan consisting of all pre-tax money. If the taxpayer rolls over that plan to a traditional IRA in the same year as the Roth conversion, the pro rata rule will cause the tax-free portion of the Roth conversion to be a smaller portion of the overall conversion, thus increasing the taxable income recognized from the conversion. If the rollover from the employer plan happens in the same year as the conversion, it must be taken into consideration in determining the pro rata amount of the conversion that is tax free, even if the rollover happens after the conversion or is rolled to a different IRA. An inadvertent rollover of a qualified plan may greatly reduce the tax benefit of converting the IRA, making a recharacterization appropriate.
The inverse of the last example is also true. Some employers offer qualified plans that allow IRA assets to be rolled into the plan-a “reverse” rollover. However, qualified plans typically do not allow nondeductible contributions to be rolled from an IRA to the plan. This exclusion can enable the taxpayer to separate the nondeductible and deductible portions of the IRA and rollover only the deductible portion to the plan. This would then leave the taxpayer with an IRA consisting of completely nondeductible funds, which could then be converted to a Roth IRA income tax free. This strategy would result in a smaller amount in the Roth IRA, but the tax cost of the conversion could be eliminated. If a reverse rollover is available, it might make sense to undo the Roth conversion and then convert again after moving the traditional IRA to the qualified plan.
When a taxpayer decides to recharacterize some or all of a Roth conversion, the amount that will be moved to the IRA must be adjusted for any gains or losses in the account attributable to the recharacterized amount. These gains or losses are net income, which is calculated as: Net income = conversion amount to be recharacterized × [(adjusted closing balance of Roth IRA × adjusted opening balance of Roth IRA) / adjusted opening balance of Roth IRA]
- Conversion amount to be recharacterized. This amount can be some or all of the original conversion amount.
- Adjusted closing balance of the Roth IRA. This is the fair market value (FMV) of the Roth IRA immediately prior to the recharacterization, plus any other distributions, transfers, or recharacterizations made from the Roth IRA since the conversion.
- Adjusted opening balance of the Roth IRA. This is the FMV of the Roth IRA immediately prior to the original conversion, plus any contributions to, or transfers or recharacterizations out of, the Roth IRA since the conversion (including the amount that is being recharacterized).
Below are several examples that show how to calculate the recharacterization amount. In each of these examples, assume a taxpayer converted $100,000 from a traditional IRA to a Roth IRA, all of which was taxable, and that he or she has no other Roth IRAs.
Example 1. The taxpayer recharacterizes the entire Roth conversion when the Roth IRA is valued at $75,000. The amount to be recharacterized is $100,000 +/- net income. The net income amount is calculated as $100,000 × [($75,000 – $100,000) / $100,000] = $(25,000).
Therefore, the amount to be recharacterized back to the IRA is $75,000 ($100,000 – $25,000), the net taxable conversion amount is $0, and the Roth IRA is worth $0 after the recharacterization.
Example 2. The taxpayer recharacterizes the entire Roth conversion when the Roth IRA is valued at $150,000. The amount to be recharacterized is $100,000 +/- net income. The net income amount is calculated as $100,000 × [($150,000 – $100,000) / $100,000] = $50,000
Therefore, the amount to be recharacterized back to the IRA is $150,000 ($100,000 + $50,000), the net taxable conversion amount is $0, and the Roth IRA is worth $0 after the recharacterization.
Example 3. The taxpayer recharacterizes $30,000 of the Roth conversion when the Roth IRA is valued at $75,000. The amount to be recharacterized is $30,000 +/- net income. The net income amount is calculated as $30,000 × [($75,000 – $100,000) / $100,000] = $(7,500).
Therefore, the amount to be recharacterized back to the IRA is $22,500 ($30,000 – $7,500), the net taxable conversion amount is $70,000 ($100,000 – $30,000), and the Roth IRA is worth $52,500 ($75,000 – $22,500) after the recharacterization.
Example 4. The taxpayer recharacterizes $30,000 of the Roth conversion when the Roth IRA is valued at $140,000. The amount to be recharacterized is $30,000 +/- net income. The net income amount is calculated as $30,000 × [($140,000 – $100,000) / $100,000] = $12,000.
Therefore, the amount to be recharacterized back to the IRA is $42,000 ($30,000 + $12,000), the net taxable conversion amount is $70,000 ($100,000 – $30,000), and the Roth IRA is worth $108,000 ($150,000 – $42,000) after the recharacterization.
Example 5. The $100,000 conversion amount went to a Roth IRA that already held $200,000, bringing the total value to $300,000. During the year, the taxpayer took a $20,000 distribution from the Roth IRA. Later, the taxpayer decides to recharacterize $30,000 of the Roth conversion when the Roth IRA is worth $350,000. The amount to be recharacterized is $30,000 +/- net income. The net income is calculated as $30,000 × [($370,000 1 – $300,000 2 ) / $300,000 3 ] = $(7,000).
Therefore, the amount to be recharacterized back to the IRA is $37,000 ($30,000 + $7,000), the net taxable conversion amount is $70,000 ($100,000 – $30,000), and the Roth IRA is worth $313,000 ($350,000 – $37,000) after the recharacterization.
Tax rules allow recharacterizations to be completed by moving specific positions rather than just cash. However, a taxpayer cannot consider only the change in value of a specific investment in a Roth IRA that holds other investments when determining the recharacterization amount. Ideally, the taxpayer would recharacterize the assets with the biggest losses and keep the assets with the largest gains in the Roth IRA, but the IRS prohibits “cherry picking” assets. Instead, it requires that all gains and losses be prorated within the entire Roth IRA as opposed to an asset-by-asset attribution.
Example 6. Taxpayer A converts $100,000 of Stock A and $100,000 of Stock B to one Roth IRA. Stock A declines in value to $75,000, but Stock B increases in value to $150,000, making the Roth IRA worth $225,000, or $25,000 more than at the time of conversion. The taxpayer would like to recharacterize only Stock A back to the IRA, but leave Stock B in the Roth IRA, thereby reducing the taxable conversion from $200,000 to $100,000. However, the anti-cherry picking rules prevent this approach. The change in the entire value of the Roth IRA must be considered when calculating the net income attributed to the recharacterized amount, not just the change in value of a specific asset in the Roth IRA. If the taxpayer wanted to recharacterize Stock A, which was worth $100,000 of the initial conversion amount, the amount to be recharacterized would be $100,000 +/- a portion of the net income of the entire Roth IRA. The net income is calculated as $100,000 × [($225,000 – $200,000) / $200,000] = $12,500. Therefore, the amount to be recharacterized is $100,000 + $12,500, or $112,500. In other words, the loss from Stock A is offset by part of the gain from Stock B.
However, if Stocks A and B had been converted to their own individual Roth IRAs, the taxpayer could have ignored Stock B when figuring the net income attributed to Stock A. The proration of gains and losses applies to only the specific Roth IRA being recharacterized, not to all Roth IRAs. By segregating the Roth conversion, the taxpayer could have achieved the goal of recharacterizing the full loss on Stock A while keeping the gains from Stock B in the Roth IRA.
Tax Reporting by an IRA Custodian
IRA custodians are required to issue a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance, Contracts, etc., to the IRA owner and the IRS on any withdrawal from either a traditional or Roth IRA. Any contribution to a traditional or Roth IRA, including one resulting from a Roth conversion, must also be reported to both parties on Form 5498, IRA Contribution Information. As a result, a Roth conversion will cause two tax forms to be issued by the IRA custodian, and a recharacterization of a conversion will result in two additional tax forms. Form 1099-R is typically issued in January following the year of withdrawal, while Form 5498 is usually issued in May following the year of the recharacterization.
The IRA custodian is required to report the Roth conversion even if the converted amount is later recharacterized. This means that if a taxpayer recharacterizes, the taxpayer will receive two Forms 1099-R and two Forms 5498; one of each for both the traditional and Roth IRAs. The reporting requirements for the IRA trustee and the taxpayer are summarized in Exhibit 2.
Exhibit 2: IRA reporting requirements
Taxpayers’ circumstances may change for any number of reasons such that it makes sense to recharacterize a Roth conversion. The IRS allows these taxpayers to recharacterize all or part of a conversion. Tax practitioners should take care to follow IRS guidelines and maintain appropriate records when conducting Roth recharacterizations.
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1 The adjusted closing balance equals the $350,000 in the Roth IRA at the time of recharacterization, plus the $20,000 previously withdrawn.
2 The adjusted opening balance equals the $200,000 balance in the Roth IRA prior to the conversion, plus the $100,000 conversion amount.