by Barry C. Picker, CPA/PFS, CFP
© 1998, Barry C. Picker
The following copyrighted article is available exclusively on the Roth IRA Web Site:
The Dow Jones is off for the day. The Market may be experiencing a major correction. My email box is full and my phone is ringing off the hook. Everyone who has converted their traditional IRA to a Roth now wants to know, "How can I undo this so I don't have to pay tax on value that is no longer there?" Then they ask, if it can be undone, can the IRA be converted again, now at the lower value? And if one does convert their IRA a second time, and the market goes down even more, can they go through this again? In the middle of this, the IRS issues proposed regulations on Roth IRAs, which hopefully answer these questions.
The good news is that any taxpayer who has made a conversion of a traditional IRA to a Roth IRA can undo the conversion. The proposed regulations add a new word to our tax vocabulary, recharacterization. (The first thing I have to do is add this word to spell check.) You are now permitted to recharacterize (another addition to the dictionary) any contribution to any type of IRA by having it transferred in a trustee to trustee transfer to any other type of IRA. Thus, besides undoing a conversion, you can also change your annual IRA contribution from a traditional to a Roth, or vice versa.
The deadline for doing a recharacterization is the extended due date of the tax return for the year of the contribution that is being recharacterized. Once the recharacterization is effected, the original contribution is treated as if it were made directly to the second, transferee, IRA.
The IRS is interpreting the language of Code Section 408(d)(6) liberally in permitting recharacterizations. Although the purpose of the statute is to provide relief to those taxpayers who either made a contribution or did a conversion that turned out would not be permitted due to too high an income, recharacterizations are permitted for any reason. This should come as good news for taxpayers whose Roth IRA is with a certain mutual fund that is prohibiting their customers from undoing their traditional to Roth conversion unless the individual can show that their income is over $100K. There is also nothing in the statute that prohibits a taxpayer from doing a new conversion after effectively canceling the first conversion by means of a recharacterization. This should come as good news for taxpayers whose Roth IRA is with a different certain mutual fund that is telling their customers that if they recharacterize their original conversion, they cannot do a second conversion. In fact, there is no legal limit on the number of times a taxpayer can convert, recharacterize, convert, recharacterize, etc.
In order for a recharacterization to be effective, net income attributable to the contribution amount must also be transferred. If the amount being recharacterized represents the entire balance that was originally contributed, and it was contributed to a separate IRA account where no additional contributions or distributions have been made to or from that account, then a transfer of the entire account balance will be deemed as including the net income (or loss) attributable to the original contribution. If the amount being recharacterized represents only a portion of the original contribution, or distributions or additional contributions were made, then the net income attributable to the portion being recharacterized is computed under the rules of Regulation 1.408-4(c)(2)(ii). A literal reading of this regulation, especially in conjunction with Regulation 1.408-4(c)(2)(iii) which defines "net income" for purposes of Regulation 1.408-4(c)(2)(ii), would lead one to the conclusion that a taxpayer could not recharacterize their conversion in a commingled account if the account has declined in value, or at least would not get any benefit from the decline in value. However I have been informed by the IRS that this is not the intended result, and that further clarification will be forthcoming. Therefore a commingled account should not be a problem.
Although the recharacterization requires a trustee to trustee transfer, this requirement will be satisfied even if both the transferor and transferee accounts are held by the same trustee and the transfer is accomplished by a paper transaction. Also, if the original conversion is accomplished by a rollover of a distribution that is deposited into the Roth IRA within 60 days but in the next year, the contribution will be treated as having occurred in the earlier year. For example, if the taxpayer withdrew IRA money from a traditional IRA in December, 1998, and deposited it into a Roth IRA in January, 1999, this would be considered a 1998 contribution to the Roth, and would have to be recharacterized no later than the extended due date of the 1998 tax return.
An individual effects the recharacterization by notifying, on or before the date of the trustee to trustee transfer, both the trustee of the FIRST (transferor) IRA and the trustee of the SECOND (transferee) IRA, that the individual has elected to treat the contribution as having been made to the transferee IRA, instead of the transferor IRA. The notification must include the following information: the type and amount of the contribution to the first IRA that is to be recharacterized; the date on which the contribution was made to the first IRA and the year for which it was made; a direction to the trustee of the first IRA to transfer, in a trustee-to-trustee transfer, the amount of the contribution and net income allocable to the contribution to the trustee of the second IRA; and the name of the trustee of the first IRA and the trustee of the second IRA and any additional information needed to make the transfer. The taxpayer must then treat the contribution as having been made to the second IRA.
The recharacterization of an IRA account is technically an election by the taxpayer. This election, once made, is irrevocable. The fact that the election is irrevocable does NOT mean that the taxpayer cannot then do another conversion of the traditional IRA to a Roth IRA. What it does mean is that if the taxpayer recharacterizes his annual contribution, he cannot change his mind. Similarly, if after the end of the year the taxpayer decides to recharacterize his conversion, that decision is irrevocable, although the taxpayer could still do a conversion for the latter year, if the taxpayer qualifies. The following are examples.
Example 1: Taxpayer converts her traditional IRA in April, 1998 to a Roth IRA. In September, 1998, she decides to recharacterize the transfer, and moves the funds back to a traditional IRA. She cannot revoke this recharacterization, but she can still do a conversion in 1998 if she meets all of the requirements. The latter conversion will be taxed at the value at the time of the conversion which may be higher or lower than the original April, 1998.
Example 2: Same facts as above except that she effects the recharacterization of the April, 1998 conversion in January, 1999. If after doing this she realizes that it would have been more advantageous to leave the 1998 conversion to obtain the four year income spread, it nevertheless is too late. The 1998 conversion has been canceled.
Example 3: Taxpayer makes an annual contribution to his Roth IRA in May, 1998. In October, 1998, taxpayer decides he would rather have contributed his annual contribution to a traditional IRA, believing that he is entitled to a deduction. He effects the recharacterization in November, 1998. In January, 1999 taxpayer learns that he was a participant in a qualified plan and therefore cannot deduct his 1998 IRA contribution. Taxpayer is now stuck with a non deductible traditional IRA contribution for 1998.
If a taxpayer has effected any transfers during the year between his traditional IRAs, or between her Roth IRAs, such transfers are disregarded. So that if the taxpayer contributed $2K to her Roth at Bank 1, and moved it to Broker 2 during the year, she can still recharacterize the contribution as having been made to a traditional IRA, by following the above procedure. In this case, the last Roth IRA account, becomes the first, transferor, IRA.
Another piece of very good news is that the proposed regulation states that a recharacterized contribution is never treated as a rollover for purposes of the once in 12 month rule. This means that taxpayers can undo their Roth conversion, reconvert, and then go through it all again if the stock market continues to fall. While it is possible that a trustee could impose internal limitations, that could always be circumvented by moving the account to another trustee.
Finally, the regulation explains what contributions cannot be recharacterized. These include tax free rollovers, SIMPLE IRA contributions, and SEP contributions. However, SEPs and SIMPLE IRAs CAN be converted to a Roth IRA, providing the taxpayer is otherwise eligible. However keep in mind that a SIMPLE IRA cannot be converted within the first two years.
So basically the news is all good on the Roth conversion front. Anyone who has
converted and has suffered a decline in market value can undo that conversion via
recharacterization, and then convert again. And if the value declines further, the process
can be repeated. So once again, there is no excuse not to convert to the Roth.
The Author:
Barry C. Picker is a Certified Public Accountant with the Personal Financial Specialist
designation, and is a Certified Financial Planner licensee. He runs his own accounting and
financial planning firm located in Brooklyn, NY, and is also a member of the NYS Society
of CPAs Estate Planning Committee. He has taught seminars and written articles on tax
topics, and has been quoted in various publications. In addition, he is part of a panel
that answers tax questions on America Online at keyword:TaxLogic. He can be reached at
(718) 934-4300, or via E-Mail at
72247.1302@compuserve.com.