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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

The reviews are in for the new edition of Natalie Choate's best-selling book Life and Death Planning for Retirement Benefits (7th ed. 2011): "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "I love the 7th edition!" "It's paid for itself already by answering several questions." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about the new edition of Life and Death Planning for Retirement Benefits, visit www.ataxplan.com.

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.

(Note: the waiting period is 30 days after the recharacterization, or until the taxable year after the year of the conversion, whichever is later. Since Caleb's conversion was in 2010, we are already into the "taxable year after the year of the conversion," so the 30-day waiting period applies. If Caleb's conversion had occurred in 2011, he would have to wait until 2012 to reconvert any amounts recharacterized in October 2011.)

Question: "Kathy" is age 73. In 2010, she converted her entire $1 million traditional IRA to a Roth (after taking the minimum required distribution for 2010). As of Dec. 31, 2010, therefore, the account balance of her traditional IRA was zero, and there is no lifetime minimum distribution requirement for the Roth IRA, so she was not required to take any required minimum distribution for 2011. As of Sept. 30, 2011, the value of the Roth IRA (originally $1 million) had declined to $700,000, so she recharacterized it back to a traditional IRA. Does she now have to take a minimum distribution from the traditional IRA for 2011, and if so, how much is it?

Answer: Yes, she does have to take a minimum distribution from the traditional IRA for the year 2011. The IRS' minimum distribution regulations, in explaining how to determine the prior year-end account balance for a traditional IRA (for purposes of determining the minimum required distribution for the current year), require certain adjustments to be made to the account balance. One time when such an adjustment is required is if a Roth conversion that occurred in the prior year is recharacterized in the distribution year.

For example, if a 2010 conversion is recharacterized in 2011, the 2010 year-end account balance of the traditional IRA must be increased for purposes of computing the 2011 minimum required distribution from the traditional IRA, to reflect the post-year-end addition of the recharacterized Roth IRA.

How much is the account balance increased by? My reading is that it is increased by the actual amount that is recharacterized, i.e., the amount of the original Roth conversion that is being recharacterized plus any earnings thereon that accrued between the date of the conversion and the date of recharacterization. In your example, the recharacterization amount was $700,000, so my reading is that her minimum distribution for 2011 will be computed as if her traditional IRA prior year-end account balance was $700,000. However, other commentators have suggested that the prior year-end account balance of the Roth IRA should be used.

Question: "Husband" converted his traditional IRA to a Roth in early 2011, then died. "Wife," as designated beneficiary of the Roth IRA, rolled the account over to her own Roth IRA. Now (with investment values tumbling), she would like to recharacterize Husband's Roth conversion. Can she do it? She is also the executrix of Husband's estate, in addition to being sole beneficiary of both the original traditional IRA that was converted and of Husband's Roth IRA.
 
Answer: I've never seen this question raised before. The regulation on recharacterization seems to say that Wife can indeed recharacterize the Roth back to a traditional IRA, even after she already rolled it over to her own Roth IRA.

Generally, recharacterization involves taking a contribution that was made to one IRA (called the "FIRST" IRA in the regulation) and transferring it (together with earnings thereon) by trustee-to-trustee transfer over to a different IRA of the other type (traditional or Roth) (called the "SECOND" IRA in the regulation). This makes it sound as though the money still has to be in the "original," "FIRST" IRA in order to have a recharacterization. However, the regulation specifically says that even if the original contribution to the "FIRST" IRA has in the meantime (i.e., before the recharacterization) been transferred via one or more tax-free transfers to one or more other IRAs, it can still be recharacterized. The money is taken out of whatever IRA it is in now and moved to the "SECOND" IRA. See Treasury Regulation § 1.408A-5, A-7. So, in my opinion, Wife can indeed recharacterize Husband's Roth conversion.

Resources: Regarding Roth IRAs generally, and Roth conversions, see Chapter 5 of the author's book Life and Death Planning for Retirement Benefits (www.ataxplan.com). Regarding how to recharacterize a Roth conversion, see ¶ 5.6.03 of Life and Death Planning for Retirement Benefits; see also ¶ 4.1.02 regarding post-death recharacterizations. Regarding the statutory deadline for recharacterizations, see ¶ 5.6.06. Regarding the minimum distribution rules generally, see Internal Revenue Code § 401(a)(9), regulations thereunder, and Chapter 1 of Life and Death Planning for Retirement Benefits. Regarding the adjustment to the prior year-end account balance to reflect post-year-end Roth recharacterizations, see ¶ 1.2.07 of Life and Death Planning for Retirement Benefits and Reg. § 1.408-8, A-8(b).

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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