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Recharacterization Riddles

How Roth recharacterization works with minimum distributions, spousal rollover, death, tax return due date, and the 30-day waiting period.

Natalie Choate, 10/14/2011

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With investment values tumbling, and the deadline for recharacterizing 2010 Roth conversions rapidly approaching, my inbox is full of recharacterization questions. Here are speedy answers to how Roth recharacterization works with minimum distributions, spousal rollover, death, tax return due date, and the 30-day waiting period.

As a reminder, "recharacterizing" a Roth conversion means undoing (reversing) the Roth conversion by transferring the converted amount (plus or minus earnings or losses thereon) into a traditional IRA. If done in a timely manner and performed according to IRS regulations, a recharacterization is treated as if the original conversion never occurred.

Question: In 2010, "Caleb" converted $300,000 of his $1 million traditional IRA to a Roth IRA. He filed his 2010 tax return before April 15, 2011, and elected to spread the income resulting from the conversion ($300,000) over two years (2011-2012). Now both his IRAs have declined by 25%. He would like to reverse his 2010 conversion. Can he? Should he? How does he do it? And once he does it, how long does he have to wait to re-convert to a Roth? (He wants to convert $300,000 again as soon as possible to catch the current market values, which he believes are low.) He has no other IRAs, either Roth or traditional.

Answer: Caleb definitely can recharacterize his Roth conversion now (until October 17, 2011), even though he already filed his tax return for 2010. The deadline for this type of statutory election is the due date of the tax return "with extensions," but IRS regulations provide that the deadline is automatically extended as long as the individual filed his tax return "on time," which Caleb did. Of course, if he recharacterizes, he will have to file an amended return for 2010, to "unreport" the conversion.

Should he recharacterize? That's a case-by-case decision. He needs to weigh the immediate tax savings of recharacterizing against the hassle of doing so and the tax cost of later reconverting (or taking taxable distributions from) the recharacterized amounts. In some cases, the higher tax bracket that will apply to future minimum distributions from the traditional IRA (which will be increased because of the recharacterization), or to a later Roth conversion of the recharacterized amount, outweigh the immediate tax savings of recharacterizing to capture an investment decline.

The next question is, when can he convert back to a Roth? At this moment, he holds a Roth IRA worth $225,000 and a traditional IRA worth $525,000, both down 25% from their values at the time of his 2010 conversion. If he wants to convert some more of his $525,000 remaining traditional IRA to a Roth IRA, he can do so at any time--he can do it right now. There is no waiting period applicable to Roth conversion of traditional IRA funds that have never been previously converted to a Roth.

The waiting period applies only to amounts that represent recharacterized former Roth conversions. So if he recharacterizes his $225,000 Roth IRA right now (by closing out the Roth account and transferring all its funds back to a traditional IRA), he could not reconvert those particular funds until 30 days after the recharacterization occurred.

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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