By: Denise Appleby, CISP, CRC, CRPS, CRSP, APA
As the deadline for recharacterizing a 2016 Roth IRA conversion approaches, practitioners will likely be consulted about whether individuals should recharacterize their 2016 Roth conversions. In cases where the Roth conversion amount has lost market value, a recharacterization might make good tax sense. In this article, we look at some of the factors that should be considered in such cases.
The deadline for completing a recharacterization is the taxpayer’s tax filing deadline. However, a taxpayer who either files his tax return or files for an extension by the due date receives an automatic six-month extension to complete the recharacterization. This means that these individuals have until October 15 to complete a recharacterization for a conversion that was done last year.
Recharacterization: A Solution for Loss in Market Value
When an individual converts amounts to a Roth IRA, he is giving up the option of deferring income taxes by including the amount as ordinary income now, for the reward of tax-free distributions later. But, if the market value of the converted funds falls below the market value at the time of conversion, the conversion may have resulted in the individual paying income taxes that could have been avoided had the conversion not been done at that time. Let’s look at an example:
- John converts $100,000 in pre-tax amounts to his Roth IRA in 2016, which is taxed at his ordinary income tax rate.
- The market value of the converted amount, which was invested in stocks and mutual funds, subsequently fell to $60,000.
- John is still required to pay income tax on the $100,000, despite the current market value.
John now owes income tax on $40,000, which could have been avoided had he waited until now to do the conversion.
Possible Fix for Market Value Loss
John can reverse the conversion by recharacterizing the $60,000 to his traditional IRA. This would result in no income tax being owed on the transaction. John can then reconvert the amount to his Roth IRA. However, John cannot reconvert the amount immediately, as there is a waiting period that must be met before a reconversion can be done.
Waiting Period for Reconversion
John cannot reconvert the amount until the later of (a) January 1 of the year following the year in which the conversion was done, and (b) 30 days after the recharacterization had been completed. Should John recharacterize the conversion now, he might be unable to predict what the market value will be when he is eligible to reconvert the amount. If the market value is higher than $100,000 by then, he would likely be paying more income tax as a result of the recharacterization and subsequent reconversion.
Calculating Recharacterization Amount
If an individual is recharacterizing the entire conversion and the Roth IRA received no source of funding other than the Roth conversion that is being recharacterized, then simply recharacterizing the entire Roth IRA balance will produce the intended results – which is nullifying the entire conversion for tax purposes.
However, if your clients want to recharacterize less than 100% of a conversion; or the Roth IRA includes other conversions, Roth IRA contributions and/or transfers from Roth IRAs, a calculation must be done to determine the current market value of the conversion amount that is being recharacterized. The formula for calculating the actual amount that should be recharacterized is available in IRS Publication 590, which can be found at www.irs.gov.
If you have clients who performed Roth IRA conversions last year and you think they might be good candidates for recharacterizations, contact them right away. This will help to ensure that the deadline is met by any who want to complete recharacterizations.
Note: this is a modified version of an article that was originally published in The IRA Digest, September 2011
Denise Appleby, CISP, CRC, CRPS, CRSP, APA is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA tools and resources for financial and tax professionals. She has over 15 years of experience in the retirement plans field, and has co-authored several books and written over 400 articles on IRA rules and regulations. Learn more at Denise’s upcoming Surgent CPE webinars: Most Tax Advantaged Ways of Getting Money Out of Your IRA or Pension Plan and 20 Essential IRA Tips for Saving Taxes and Avoiding Penalties.