Ramifications of Cash Conversion Buying and Selling
A client of ours is considering converting cash/ money market equivalent of TIRA into a new Roth. If the cash is used to buy $10k in an equity position and then it decreases in value to 8k and the client sells to stay in cash/ MM. How would the recharacterization work?
Taking this scenario one step further, What if the client takes the 8K from the proceeds of previous sell to invest bonds and grows it to 8.5K. How would the recharacterization work?
Permalink Submitted by Alan Spross on Fri, 2010-01-15 03:18
The earnings that must accompany a recharacterization is actually a fairly simple calculation. The entire investment experience of the Roth while it is holding the Roth conversion is considered and the experience of individual holdings is immateral.
In the first example, the conversion of 10,000 has decreased to 8,000, ie a loss of 20%. Therefore, since only 80% of the original conversion remains, only 8,000 goes back to the traditional IRA. It does not matter how many trades are done and when, only the opening dollar balance and the closing dollar balance matters.
For the second question, the value of the account upon recharacterization is 8,500, so now you have a loss of 15%. With a loss of 15%, 8,500 is the amount that goes back to the TIRA.
As for what holdings go back, it does not matter. It should be your choice from all current holdings in the Roth IRA at the time or recharacterization. This also includes any holding that had been in the Roth before the conversion was done. The only thing that matters is the dollar value that moves back to the TIRA in a recharacterization.
Permalink Submitted by Anonymous (not verified) on Fri, 2010-01-15 22:55
alan:
Just to follow up on one odd thing and maybe you heard of this:
On a full recharacterization without additonal money in the Roth pool the IRS calculation is actually flawed. If you keep with the formula ([Adjusted Closing – Adjusted Opening]/Adjusted Opening), some money will be left behind, when it should all move back to the TIRA. Some custodians are dumbfounded when you argue that point, but eventually they get it and need to ignore their calculation platform.
pmk
Permalink Submitted by Alan Spross on Fri, 2010-01-15 23:20
I have not heard of this. I am aware of distortions when there are contributions or distributions between the conversion and recharacterization resulting from the adjustments to the two balances, but not for a simple earnings gain or loss with no intervening transactions, ie when the only contribution in the account is the conversion and the only withdrawal is the recharacterization?
Do you have an example of this other problem?
Permalink Submitted by Anonymous (not verified) on Fri, 2010-01-15 23:29
alan:
I am going to try to come up with a scenerio. I will get back to you later this weekend.
pmk
Permalink Submitted by Anonymous (not verified) on Sat, 2010-01-16 03:22
alan:
I thought about this again and I think I was a bit confused. Here is what I meant:
I dealt with this when trying to diagnose processing errors for an IRA custodian. In our case, a computer program calculated the recharacterization based on the formula. Many processors did not look at whether it was a full or partial recharacterization and applied the program. If you follow the earnings calculation the “Adjusted Closing Balance” always use the prior day value, although the money moves the next day. If a mutual fund increases in value the amount calculated never depletes the whole account and thus, the owner is questioning why a small balance is left in the Roth IRA.
So, I guess this is not a flaw per se, but something one needs to familar with in the processing world.
[u]Calculation Not Required for Full Recharacterization[/u]
http://www.investopedia.com/articles/retirement/03/092403.asp
pmk
Permalink Submitted by Alan Spross on Sat, 2010-01-16 04:46
Thanks.
It appears the solution is to terminate systems calculation activity on all full recharacterizations, and simply transfer the full account balance back to the TIRA. That would eliminate very small balances left behind and the accompanying expense of maintenance. You posted that paragraph in Denise’s article, and here is the appropriate IRS Regulation. See 2) Special Rule:
http://www.taxalmanac.org/index.php/Treasury_Regulations%2C_Subchapter_A…
Permalink Submitted by Mike Marangola on Wed, 2010-01-20 07:14
Very helpful topic and discussion.
In the formula:
([Adjusted Closing – Adjusted Opening]/Adjusted Opening)
how do we calculate or define adjusted closing and opening?
Thank you.
Permalink Submitted by Anonymous (not verified) on Wed, 2010-01-20 17:08
from the link I posted above. The bold part describes the key definition of “prior”, which essentially means the trade date and balance prior for most investments, like mutual funds.
•’Adjusted opening balance’ represents the fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is being recharacterized and any other recharacterizations) made to the IRA during the computation period.
•’Adjusted closing balance’ is the fair market value of the IRA at the end of the computation period plus the amount of any distributions, transfers or recharacterizations made from the IRA during the computation period.
•[b]The computation period begins immediately prior to when the contribution being recharacterized is made to the IRA and ends immediately prior to the recharacterizing of the contribution. If the IRA is not valued on a daily basis, then the most recent available fair market value preceding the contribution may be used as the beginning of the period, and the most recent available fair market preceding the recharacterization is the ending fair market value. [/b]