Handling of failed Roth conversion…
Did a Roth conversion for a client in 2010. The REIT lost some of it’s value therefore we recharacterized the conversion. After 30 days had elapsed we then reconverted at the lower market value. Unfortunately I failed to recognize that the reconversion was not allowed to take place until the first of this year (2011). I’ve talked with a couple of CPA’s about how to handle this and am getting different answers. One of them suggested recharacterizing again and submitting a letter of explanation to the IRS with their tax return (they’ve filed an extension) simply explaining that it was an honest mistake. Another said that we may have to treat it as a failed conversion and pay and excise tax on the distribution? Any thoughts on this matter?
Permalink Submitted by Alan Spross on Tue, 2011-04-19 17:10
As long as they filed a timely extension, they have until the extended due date to recharacterize the failed conversion. That is relatively painless, but it becomes a disaster if the extended due date passed without recharacterizing (10/17/2011). This is allowed in the tax code so there is no need for a special letter to the IRS, although an explanatory statement should be included with the tax return explaining both conversions and recharacterizations (dates and amounts). While there is a rule that a tax free transfer cannot be recharacterized again, this rule does not apply to conversions because they are not tax free transfers.
Once this is done, only the 30 day waiting period applies for another conversion because these prior conversions were in 2010. Of course, the 2 year deferral of the conversion income has now disappeared.
However, before acting the client should make sure that the second conversion was in fact a disallowed reconversion. It is OK to convert different assets than the ones recharacterized. For example, if client has other TIRAs or a balance in the original TIRA that exceeded the conversion amount by the amount of the conversion, this would not be a failed conversion, just another conversion deemed to come from different assets. A failed conversion is typified by someone who converts their entire TIRA and therefore the second conversion is obviously coming from the same assets. Don’t pay any attention to the actual type of investments that were moved, just whether there were other available assets in the TIRA or other TIRA to convert. If there were, then the second conversion is valid.