by Natalie B. Choate, Esq.
© 1998, Natalie B. Choate
As they first appeared, the IRS’s proposed Roth IRA regulations seemed to allow an infinite number of "unconversions" followed by "reconversions." This prospect led some to believe they could engage in fine tuned "market timing" of their Roth conversions for tax purposes.
In an attempt to limit "market timers" who would, if they could, unconvert and reconvert their Roth IRAs every time the market dipped, the IRS in Notice 98-50 (October 1998) has already amended its proposed Roth IRA regulations (issued September 1998). Basically the new rule is: you get two bites of the apple.
Specifically, for 1998 and 1999:
1. The general rule is, a person may convert the same amount to a Roth IRA no more than twice in any one calendar year. That is to say, he can convert an IRA amount to a Roth (first conversion), then "unconvert" (recharacterize) it, then "reconvert" it (second conversion, or first "reconversion"). After that he can continue unconverting and reconverting as many times as he chooses -- but any subsequent reconversions are considered "excess reconversions" and will not be used to determine the amount includible in gross income on account of the Roth conversion.
If the last step is a reconversion (so that when the music stops -- on the extended due date of the person’s tax return -- the amount is in a Roth IRA, not a traditional IRA), gross income will still be based on the amount converted in the "first reconversion."
Here are the exceptions to and variations of this general rule:
2. Reconversions prior to November 1, 1998 don’t count toward the 1998 limit. So anyone who converts to a Roth IRA at any time in 1998, and then unconverts at any time in 1998, may do one reconversion (or one more reconversion, as the case may be) between November 1 and December 31, 1998, regardless of how many reconversions (if any) she did prior to November 1, 1998.
3. Anyone who converts to a Roth IRA at any time in 1998, and then unconverts at any time in 1998, may also do one (and only one) reconversion of the same amount in 1999. In other words, if a person unconverts a 1998 Roth conversion and when the music stops (on December 31, 1998) the amount is in a traditional IRA (because of an unconversion), that person may "reconvert" that amount only once in 1999, regardless of:
(a) whether or not he took advantage of the opportunity to do one "unconversion" in the period November 1, 1998 to December 31, 1998, and
(b) how many re-or un-conversions he may have done before November 1, 1998.
Note that this 1999 "reconversion" will be a 1999 conversion, not a 1998 conversion, so it will generate gross income in 1999 (only), and is not eligible for the four year spread. But it does "look back" to the 1998 tax year, in that it applies to a person who did an unconversion of a 1998 conversion--and stayed unconverted, as to that amount, as of the end of 1998. (That’s what makes this a reconversion of the "same" amount--if a person had unconverted in 1998, then reconverted, so at the end of the game he in fact did have a 1998 conversion, the 1999 conversion would be a new conversion--not a reconversion of the same amount.)
4. This particular limit (in Rule 3) does not apply to a person who unconverted his 1998 conversion(s) because he was not eligible to convert, i.e., whose 1998 conversion attempt(s) failed because his income turned out to be over $100,000. The Rule 3 limit applies only to a person who, though he was eligible to (and did) do a 1998 Roth conversion, "unconverted" that conversion and ended up with the amount still (or back) in a traditional IRA at the end of calendar 1998.
5. The limit in Rule 3 does not affect a person whose 1998 Roth conversion ultimately ended up 1998 in a Roth IRA, regardless of how many times he flipped it back and forth before the end of 1998. Since this person’s 1998 Roth conversion ultimately stayed "converted," any 1999 conversion is a "new" conversion, not a reconversion of an unconverted 1998 conversion. So this person gets a fresh start for 1999. For a new (1999) conversion, he can unconvert and still reconvert.
It’s all so easy once you know how!
6. These rules apply for 1998 and 1999, while the IRS considers whether it wants to (prospectively) further limit (or eliminate) reconversions.
Example: Cuthbert converted his $1 million traditional IRA to a Roth IRA on June 1, 1998. By September 1, 1998, it had declined in value to $900,000. Taking advantage of the generous terms allowed for "unconversions," Cuthbert "recharacterized" the Roth back into a traditional IRA...then promptly reconverted the traditional IRA (now worth $900,000) to a Roth. By October 1, 1998, the account had declined in value to $800,000, so he "unconverted" (recharacterized) and reconverted again. His intention was to keep doing this every time the market value of the account declined, right up until the December 31, 1998 deadline for 1998 Roth IRA conversions, so as to minimize the amount that would be includible in his gross income on account of this conversion.
Then in October the IRA issued Notice 98-50, eliminating the tax advantages of multiple reconversions. By November 1, Cuthbert’s Roth IRA has declined in value to $700,000, and he can’t resist "unconverting" and "reconverting" one more time. Notice 98-50 does permit him to do this, because everyone is permitted one reconversion between November and December 31, 1998, "even if the taxpayer has made one or more reconversions before November 1, 1998."
By December 1, 1998, Cuthbert’s Roth IRA has further declined in value, to $600,000. He now has the following choices:
A. He can do nothing. Then the $700,000 Roth IRA conversion on November 1, 1998, will be included in his gross income. In other words, he will have to pay tax on $700,000, even though the account is now worth only $600,000. Because the conversion was done in 1998, he can elect to spread the income over four years.
B. He can unconvert, as in choice B, and then reconvert to a Roth by December 31, 1998. However, since he has already done one "reconversion" on or after November 1, 1998, this reconversion (and any others he does before 1999) are "excess reconversions." Accordingly, his gross income reportable as a result of any or all of his post-October 31 reconversions will remain the same; it will be based on the last prior reconversion that was not an "excess reconversion," namely the one that occurred on November 1, 1998. Therefore, if he unconverts and reconverts again after November 1, the tax result will be exactly the same as under choice A -- $700,000 of taxable income.
C. He can "unconvert" (recharacterize) the November 1, 1998 conversion and then call it quits for 1998. The effect on his 1998 tax return will be as if he had never done any Roth IRA conversion. He will not have any gross income on account of the Roth conversions because in effect they never occurred. His money remains in a "traditional" IRA. Maybe he will decide to try again next year. If he chooses this Option B, "unconversion," and then does convert again in 1999, the first 1999 "conversion" will be considered a permitted "reconversion" of the 1998 conversion/unconversion(s). Thus, his 1999 gross income will be determined by this first 1999 conversion, but with no further 1999 "reconversions" allowed.
Roth IRA Glossary
Failed conversion. Taxpayer converted all or part of his traditional IRA to a Roth IRA, but was not eligible to do so because his income exceeded the income limit. This taxpayer should "unconvert" (recharacterize) his Roth IRA conversion by transferring the amount converted (plus its earnings -- or minus its losses, as the case may be) back to a traditional IRA on or before the (extended) due date of his tax return for the year in which the failed conversion occurred. If the failed conversion occurred in 1998, the "unconversion" of it before the due date of the 1998 return will not "count" towards his 1999 reconversion limit. See IRS Notice 98-50, example 5.
Recharacterization. The IRS’s term for undoing a Roth IRA conversion. A taxpayer who has converted all or part of a traditional IRA to a Roth IRA (whether by means of a "failed" conversion, a "reconversion," an "excess" reconversion or just a plain old "conversion") may undo (recharacterize, unconvert) that conversion at any time up until the (extended) due date of his or her tax return for the year in which the conversion occurred. Until that (extended) due date, the door is always open for unconversions; there is no limit on the number of times a person may "recharacterize." (Only "reconversions" are limited.)
Reconversion. The conversion, from a traditional IRA to a Roth IRA, of an amount that has already been converted (to a Roth IRA) at least once in the same taxable year.
Excess reconversion. A reconversion in excess of the limit imposed by Notice 98-50. An "excess conversion" is a valid Roth contribution; the Roth IRA so established is recognized in all respects. However, the individual’s taxable income resulting from the "excess reconversion" will be based on the value converted in the last "valid" (non-excess) reconversion to a Roth that occurred prior to the "excess" reconversion. In other words, a person making an "excess reconversion" will pay tax on the value of the converted amount as of the last preceding reconversion that was not an "excess reconversion." The value actually converted in the "excess reconversion" transaction is irrelevant. And if the taxpayer doesn’t like this result he can still undo all the conversions by "unconverting" back to a traditional IRA prior to the due date of his tax return.
Author:
Natalie Choate is of counsel to the law firm of Bingham, Dana, L.L.P., in Boston. She
is the author of what is generally regarded as the best available book on
pension distribution planning, Life and Death Planning for Retirement Benefits.
For a list of speaking engagements by Natalie Choate, see her Ataxplan web site.