Roth Re-characterization and Roth Conversion in same year

Submitted by Rene Nourse on Wed, 2017-09-20 20:28

For the past 4 years, a client has been doing Roth conversions. However, due to his accountant not reporting the 2016 conversion, he has recommended re-characterizing 2016’s instead before IRS catches it. The client turns 70 1/2 next year and this year, will be the last “clean” year that we can do a conversion without having to take RMD’s also. Question is this: if 2016’s conversion is re-characterized AND we do a Roth conversion in 2017, including the re-characterized funds, how will it affect the conversion strategy for 2017? For example, will it fall under the pro-rata rule?



Submitted by Alan - IRA critic on Thu, 2017-09-21 01:05

  • Not sure if client should recharacterize just to avoid filing a 2016 1040X. His 2016 conversion likely has positive gains on it and recharacterizing would send those gains from the Roth back to a TIRA where they eventually will be taxed. A recharacterization (2016 conversion deadline is 10/16/2017) will also increase his 2017 year end balance and his 2018 RMD unless he does a new conversion this year equal to the amount transferred in the recharacterization. Or he might want to do a new conversion in 2017 since this is the last year he can convert without doing an RMD first. 
  • The pro rata rule applies if he has basis in his TIRA from non deductible contributions. Taxation of distributions (conversions and RMDs) is calculated based on the adjusted year end value of his non Roth IRAs. If he has basis, part of his 2016 conversion will be non taxable and the same for any 2017 conversions done. But the year end value is one year later for 2017 conversions.  Recharacterizing the 2016 conversion will add both value and basis to his TIRA, so the taxable portion for both conversions would be about the same.

Submitted by Rene Nourse on Thu, 2017-09-21 21:11

Thank you – apparently the funds were not invested, and have been in cash the past year, so we don’t have to worry about that issue. I agree with you about filing a 1040X- but I think his accountant is pushing back since he had agreed to pay the penalties for not including it on the client’s tax return.If he does re-characterize and turns around and converts that amount PLUS additional funds in order to get a bigger bang for his buck in 2017, that would be ideal.  Just wanted to make sure that if we do re-characterize and converted that same amount plus more that it wouldn’t compromise the strategy.  It sounds as if it won’t be a problem. 

Submitted by David Mertz on Thu, 2017-09-21 23:41

  • Since the client would not be the one on the hook for the penalties and interest, one has to consider only whether recharacterizing and converting more later would be detrimental to the client’s long-term financial position.  If the Roth IRA account has seen investment gains since the conversion, the answer might be that recharacterizing would put the client in a worse financial position because these gains would then become taxable when later distributed from the traditional IRA as a regular distribution or a future Roth conversion.  However, that also depends on future investment performance, and that depends on the type of investments in the traditional and Roth IRAs.  Given that one generally invests with the expectation that there will be gains, it seems that recharacterizing a conversion that has gains would, on average, be detrimental in this respect.
  • Second, even if there are no gains and recharacterizing made sense from that standpoint, recharacterizing and later converting that amount plus an additional amount in the same year could cost the client more in taxes if the larger amount converted in one year resulted in some of the conversion being taxed at a higher marginal tax rate.  One typically tries to convert only as much as can be converted without some of the conversion falling in the next-higher tax bracket.  This means that recharacterizing wouldn’t change the amount that one would typically convert, except in the case where otherwise wouldn’t have enough traditional IRA funds to convert to be able to fill up the current tax bracket.  If one is following this strategy, the effect of recharacterizing would be to move the conversion to the tail end of the conversion plan, potentially delaying the conversion by several years and resulting in more tax being paid due to growth in the meantime.
  • If I was the client, I would resist being put in a worse long-term financial position just to save the accountant some money.  The implication would be that the accountant has a conflict of interest and is not operating in the best interest of the client.

Submitted by Rene Nourse on Thu, 2017-09-21 23:44

Got it!  thank you.

Submitted by David Mertz on Thu, 2017-09-21 01:57

Perhaps there is a desire to avoid the late payment penalty and interest on the additional taxes due with the amendment, but at 6 months late the penalty and interest in most cases would probably only amount to between 1% and 1.5% of the taxable amount of the conversion.  If it was me, that would not be enough to justify recharacterizing.  I would have to have another reason to recharacterize rather than amend the 2016 tax return.

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