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2011 Decisions for 2010 Conversions

We'll all still be working on our clients' 2010 Roth conversions until Oct. 17, 2011!

Natalie Choate, 03/11/2011

The new 7th edition (2011) of Natalie Choate's book Life and Death Planning for Retirement Benefits is here! The new edition brings this classic book up to date for the latest cases, rulings, and IRS pronouncements, plus includes NEW material: "Road Maps" for advising clients, drafting forms, calculating distributions, and more. A "see-through trust tester quiz." And more coverage of after-tax money in plans, post-death choices, and everything "Roth" (including the new "in-plan Roth conversions"). Order at www.ataxplan.com, amazon.com, or by calling 800-247-6553.

Do you have your own solutions/suggestions? Leave a comment at the end of the article!

Question: In 2010, I converted my $700,000 traditional IRA to a Roth IRA (Roth IRA #1), and I also did an "in plan" conversion of $80,000 from my traditional 401(k) plan account to a designated Roth account in the same plan. My wife converted $300,000 from her traditional IRA to a Roth IRA (Roth IRA #2), and also rolled over $100,000 from her traditional 401(k) account into a separate Roth IRA (Roth IRA #3; not the same as the account into which she converted her traditional IRA). We did all this because we thought income tax rates were going to go up in 2011. Now we're looking at paying income taxes, for 2010, on $1,180,000 of Roth conversions, and we're not sure we like that idea. What makes it worse is that some of the investments in my Roth (formerly traditional) IRA account have declined in value since the conversion, so my Roth IRA #1 is now worth only $600,000. What are our options for undoing any of these conversions, or at least minimizing the immediate tax hit, and what deadlines do we face? If we undo some of the 2010 conversions, can we reconvert to a Roth this year?

Natalie: There are two ways to alleviate the income tax hit on a 2010 Roth conversion. One way is to "recharacterize" (undo) the conversion; this option is available for any conversion to a Roth IRA, but is not available for your in-plan conversion. The other way is to spread the conversion income forward into 2011-2012. This option is available for both kinds of Roth conversions.

First we'll look at what you can and cannot do by way of recharacterizing and income-spreading. Then we'll look at the timeline: Your deadlines for actions and decisions in connection with 2010 Roth conversions.
You and your wife have the option to "recharacterize" any 2010 Roth IRA conversion. This option enables you to simply erase the conversion, as if it never occurred. This option is available for any Roth conversion except an "in-plan" conversion. An in-plan conversion is irrevocable, so you cannot undo the conversion of $80,000 from your traditional 401(k) plan account to a designated Roth account in the same plan.

Here are the benefits and limits of your option to recharacterize the other Roth conversions:

* Recharacterizing means undoing a Roth conversion. You "recharacterize" your contribution to the Roth IRA as a contribution to a traditional IRA. You do this by transferring the contribution, plus the "earnings" on the contribution, from the Roth IRA to a traditional IRA. This MUST be done by "IRA-to-IRA transfer." If you actually withdraw the money from the Roth IRA and pay it to yourself, you have a distribution, not a recharacterization.

* The recharacterization is done by transferring the contribution (and related earnings) to a traditional IRA, even if the original conversion came from a non-IRA plan. For example, to recharacterize her conversion of $100,000 from her traditional 401(k) plan to a Roth IRA,  your wife would transfer the $100,000 (plus or minus its earnings) to a traditional IRA, not back into her 401(k) account.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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