We'll all still be working on our clients' 2010 Roth conversions until Oct. 17, 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.
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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.
* In computing the "earnings" that must be transferred to a traditional IRA along with the contribution in order to effect a recharacterization, you must prorate the earnings (or losses) of the entire Roth IRA that received the contribution. For example, you converted $700,000 from your traditional IRA to a single Roth IRA. Since the conversion that Roth IRA has received no other contributions and made no distributions, and now it is worth $600,000. You can undo the entire conversion by transferring $600,000 to a traditional IRA. That would be considered a return of the $700,000 contribution plus the "earnings" on the contribution, which were "minus $100,000."
* You can recharacterize the entire Roth conversion, or you can do a partial recharacterization. However the partial recharacterization must be done on a percentage basis; for example, you could recharacterize 50 percent of your $700,000 conversion by moving half the contribution (plus half the loss) (i.e., net $300,000) to a traditional IRA. But you cannot just recharacterize certain assets in the account, so you cannot just recharacterize the "losers."
* Your wife converted her traditional IRA and her 401(k) plan distribution into two separate Roth IRAs. She can recharacterize these contributions separately because they were placed in separate accounts. For example, if her Roth IRA #2 declined in value while her Roth IRA #3 increased in value, she might choose to recharacterize only Roth IRA #2.
The "price tag" for recharacterizing is that you cannot re-convert the same amount for a certain period of time, namely, until the later of 30 days after the recharacterization or the year after the year of the original conversion. So if you do a recharacterization in March 2011, for example, you would have to wait 30 days before you could do a Roth conversion of the recharacterized amount (since we are already into the taxable year following the year of the conversion). If you have other traditional plans or IRAs that were not involved in the original Roth conversion that was recharacterized, you can convert such other plans/accounts without waiting the 30 days. It is only the "same amount" that cannot be reconverted until after the waiting period.
The Election to Push 2010 Conversion Income Into 2011-2012
This is a one-year-only deal, valid for Roth conversions in 2010 ONLY. You can elect to have the income resulting from your 2010 Roth conversions spread forward into 2011 and 2012, or have it included in your income all in 2010. If you do nothing, the law presumes that you have elected to spread the income forward; you actually have to elect OUT of this deal if you don't want to have that happen.
You and your wife can make different elections. So you could have your 2010 conversion income spread forward into 2011-2012, while your wife elects out of that deal, and reports her $400,000 of 2010 Roth conversion income all in 2010.
You can make one election regarding your in-plan Roth conversion, and a different election regarding your Roth IRA conversion. So you could elect the two-year spread for the $700,000 IRA-to-Roth-IRA conversion (assuming you don't decide to recharacterize it) while taking the $80,000 of in-plan conversion income into your income in 2010.
In contrast, your wife cannot make different elections in this regard for her two 2010 Roth conversions. Even though she converted money from two different sources (her traditional IRA and her traditional 401(k) plan), and even though she converted those different plans into two separate Roth IRAs (Roth IRA #2 and Roth IRA #3), and even though she could make the recharacterization election separately for those two separate conversions, she must make the SAME election regarding income-averaging for her two 2010 conversions, because both conversions went into Roth IRAs. Unlike you, she did not do an "in-plan conversion."
Timeline and Deadlines
April 18, 2011, is the due date for individuals' 2010 individual income tax returns (Form 1040). Even if the individual obtains an extension of the due date of the return (to Oct. 17, 2011), any tax due on 2010 income is still due and payable on April 18, 2011. Although failing to pay the tax by April 18 does not void the extension of the return, by the same token, obtaining an extension of time to file the return does not extend the due date of the tax.
This means that, even if you obtain an extension of your return, you will have to pay the income tax on your $1,180,000 of 2010 conversions by April 18, 2011, if you want to be sure of avoiding the penalty for late payment of tax. Of course if by that date you have already recharacterized one or more of the conversions you don't have to pay the tax on such conversion(s) because you already know you won't owe it. But if you have not recharacterized by April 18, and then you don't pay the income tax on the full conversion, you will owe interest and penalty on late-paid taxes unless you later either (1) recharacterize your 2010 conversions or (2) elect to push the income from the 2010 conversions forward into 2011 and 2012.
Thus, although theoretically everybody has until Oct. 17, 2011, to decide whether to recharacterize 2010 conversions and/or push the income from 2010 conversions into 2011-2012, as a practical matter, you will have to do some deciding by April 18: Either pay the tax in full on your not-yet-recharacterized 2010 conversions, or later be faced with a penalty for late payment of tax if you do not choose to either recharacterize or defer the income resulting from 2010 conversions.
Resources: For deadlines for 2010 returns and extensions, see Instructions for IRS Form 1040. For more on the election to push income forward into 2011-2012, see IRS Form 8606 and Instructions. For complete detail and citations regarding all aspects of Roth IRAs, Roth conversions, designated Roth accounts, recharacterizations, in-plan conversions, and everything else "Roth," see Chapter 5 of the newest edition of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed., 2011), which can be purchased through www.ataxplan.com, Amazon.com, or 800-247-6553.
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