Partially undoing a Roth IRA Conversion

Submitted by Terry Koch on Fri, 2010-03-19 21:26

I plan to convert my TIRA to a Roth IRA and keep the converted IRA separate from my other Roth IRA’s. I understand that you can undo a conversion until 10/17/11. My question is: Can only a portion of the conversion be undone? Say I convert a $700,000 TIRA to a Roth IRA. Could I subsequently undo $200,000 prior to 10/17/11 and keep the remaining $500,000 in the converted Roth IRA? Or is it an “all or nothing” proposition?



Submitted by Alan Spross on Fri, 2010-03-19 21:36

Sure, you can do either a partial recharacterization or a full recharacterization. You can also do a partial for one conversion and a full for another conversion. Therefore, the 10/17/2011 deadline applies to all these options:
1) Taking each particular conversion done in 2010, recharacterize all or part of it
2) Decide to defer the income for two years or OPT OUT of the deferral and report all conversions in 2010. Here you cannot mix and match, it is either all your conversions deferred or all of them reported in 2010.

By October, 2011 you will completely know your 2010 tax liability and will have a very good idea of your 2011 tax liability, but probably much less of a feel for your 2012 tax liability. But if 2011 rates increase in your bracket, you can certainly recharacterize some of the conversion to make it smaller and then report what is left in 2010, thus avoiding a 2011 and 2012 tax increase. Of course, you could still convert smaller amounts in 2011 and 2012 as you go.



Submitted by Terry Koch on Fri, 2010-03-19 21:51

Thanks for the quick response. I have another question concerning payment of 2010 income taxes on 4/15/11. I realize that you can take an extension until 10/17/11 but the tax liability is actually due on 4/15/11. What happens if a person is planning as of 4/15/11 to defer paying the tax until 2011 and 2012, but then prior to filing his extended 2010 tax return decides to pay it all in 2010. Isn’t he going to be subject to large underpayment penalty because the 2010 tax wasn’t paid on 4/15/11? Is there any way to get around this?



Submitted by Alan Spross on Fri, 2010-03-19 22:13

The only way to get around it is to meet a safe harbor. Generally, this means paying in through withholding or equal quarterly estimates an amount not less than 100% of your 2009 tax liability (110% if AGI over 150,000) or 90% of the 2010 tax liability. Since reporting a considerable conversion in 2010 will increase income for most people, the 2009 tax liability would be the best indicator and it is also much more determinable. Of course, this only means there will be no underpayment penalty. You still would probably have to come up with a considerable tax payment.

That same safe harbor would work for the two year deferral as well, ie pay in based on the 2010 tax for 2011 and the 2011 tax for 2012. But for 2013 when the income would drop way back, you would probably switch to the 90% of current year safe harbor.



Submitted by Terry Koch on Fri, 2010-03-19 22:29

Thank you. I was thinking that I would be subject to an underpayment penalty if the entire amount due was not paid by 4/15/11. However, I believe that I would only be subject to interest on the amount of the underpayment from 4/15/11 until the tax was paid. However even the interest amount could be substantial.



Submitted by Alan Spross on Fri, 2010-03-19 23:21

Yes, the post 4/15 interest until date of payment would also be part of this exposure. Even though the time frame is only half the pre April time frame, interest rates could also be higher over a year from now. You would just have to hedge against the chance of making that decision by paying in even more than the safe harbor to eliminate this interest exposure as well. You would get that back around 4/11 if you filed then and stuck with the two year deferral, but if you later amended out of the two year deferral, there would be some interest due.



Submitted by Terry Koch on Sun, 2010-03-28 00:59

I have a question on the mechanics on partially undoing a Roth IRA conversion. What happens if there has been a lot of turnover post-conversion in the securities in the converted account? The securities that are now held in the converted account are completely different than the securities that were initially converted. Now I wish to partially undo the conversion but the assets initially converted are no longer there. Is it a matter of tracing all the purchases and sales back to the point at which the conversion took place? I assume that there must be some flexibility in this because in many cases, it might be impossible to determine which securities were purchased by which funds, particularly if monies from sales were co-mingled and held for periods of time before purchases were later made. It seems like this could be quite a task if there was a lot of activity in the account or is there a simpler way of doing it?



Submitted by Alan Spross on Sun, 2010-03-28 03:40

It is not nearly as complex as you think. Recharacterization is no more work if you make a 100 trades than it is if you make none. The only thing that matter is the difference between your opening value upon conversion and the closing value when you recharacterize. A set formula then calculates HOW MUCH income must go back to the TIRA. If you have a total gain, then more goes back than you converted, and it you have a loss, then less goes back than you converted.

As to WHAT investment are transferred back to equal the amount of dollars the formula indicates, that is your call. Assume the formula indicates that 30,000 must go back on a 25,000 conversion because you had a 20% gain. You then decide which assets you want to use to make up that 30,000. You can tell the custodian to use all of your shares of A and B, and half your shares of C, and if that is not enough to use D to bring the total to 30,000. In making your choice, it is best to send the shares you think will perform the worst back to the TIRA and keep the investment you feel will gain in the short term in the Roth. Of course, if an investment does not look good, just sell it and replace it in EITHER account.

With respect to the above formula, if you do a conversion into a new Roth account that holds ONLY that particular conversion, then no formula is needed. The account balance itself determines the amount to recharacterize. If you want to recharacterize half of that conversion, then you must select holdings that equal half of the current value of the account and advise the custodian. Don’t leave the decision of what assets to move up to the custodian, as you might not approve of their selection. Most recharacterization forms have a specific section in which you can make your choice of assets.

Where you DO run into problems is when you convert to a Roth and then transfer the Roth to another broker. The new broker is not going to know what your opening balance was and may refuse to calculate the earnings. IRA custodians usually do, but are NOT required to do the calculation.

Here is the formula if you ever have to do it yourself or just want to understand it better:
http://www.retirementdictionary.com/definitions/netincomeattributablenia



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