Recharacterization (comments welcome from alan-oniras)…
Good afternoon, you have replied to most of these questions and seem to be on top of it…
I have a Roth IRA created a few years ago by converting from Traditional (all within Fidelity). I do this early in the year assuming on average assets will appreciate but that is not the case this year.
1) I would like to recharacterize everything I did in Jan/Feb (13.6k then; worth $5.7k or so now). When talking to Fidelity, I can fill out the form and indicate the 3 items I want to recharacterize. These assets are comingled with previous years funds that I’ve converted (everything in one common traditional IRA going into one common Roth). The Fidelity rep was trying to explain to me I might not be recharacterizing exactly what I converted, pending the outcome of worksheet 1-3 found on p. 31 of IRS article 590. He made it sound like some of prior years converted assets may have to be recharacterized as well depending on how the formula works out. I do not have all the figures to complete this worksheet but this doesn’t make any sense to me — can you explain?
2) I would like to take other assets from the TIRA and move to Roth for this year, judging by your comments on other posts on this topic, it would appear the recommendation is to create a new Roth for this transaction so it’s easy to show the assets are different?
3) Next year I think I will convert all remaining Traditional IRA to Roth, then recharacterize the lowest performers (saw another post on this, it’s a great idea) to be converted the following year. Again, would it be best to convert everything into individual Roth accounts so I don’t have to deal with recharacterizing comingled assets? Should I split up the TIRA too?
Anything else you can think of that I’m missing?
Thanks for your time and advice.
Permalink Submitted by Alan Spross on Wed, 2008-11-05 01:10
1) Since your conversion was done to an prior Roth IRA account, the amount to be recharacterized depends on the investment experience of the entire account, not just the assets you converted this year. The worksheet you refer calculates the amount that is recharacterized back to the TIRA. You should have the choice of selecting any assets in the Roth that you wish, as long as they add up to the correct value on the date of recharacterization.
For example, the assets you converted fell about 60% in the Roth. That’s much more than the market as a whole, so let’s say the account in total fell 25% during the period of the conversion. You would then recharacterize back 75% of the value of your conversion, but those assets are now worth only 40% of their converted value. The extra 35% has to come from other assets. You will run into this anytime that your converted assets fall more than the account overall. Note that you can recharacterize any assets you wish, in fact you could retain all the most recent converted assets in the Roth and recharacterize prior assets that add up to the required total adjusted for the losses. Many people no longer even have the same assets when they recharacterize because they have sold them in the meantime.
2) Right. Since you are planning another conversion this year, you need to be sure it does not look like a disallowed reconversion. The amount should be different, and if you do the conversion prior to the recharacterization, send it to a new Roth account. If you do the recharacterization first, have it sent to a new TIRA account. The recharacterized funds are never in the same account that you do additional conversions from. These extra accounts can be recombined after all deadlines have passed, a couple years later.
3) If you are doing several conversions at the same time, do each to a separate Roth. That will eliminate any worksheets to calculate earnings, as the difference of value in each account from the conversion will be the earnings plus or minus. Just basic subtraction, and the best performiing account will be obvious. You don’t need more than one TIRA in that case because you would normally not recharacterize until the following year and would therefore not be doing reconversions.
Since you have the advantage of making a retroactive decision on your conversions after both your tax bill and investment experience are known, generally you would not recharacterize as early as you doing now. You would wait until the following year. However, the drop in the market has been so severe that it is almost sure not to recover those losses in the next 12 months, so this year is different.
Remember, for this strategy you would probably want to extend your tax return to October, and not file it until you have done your recharacterizations. You also have to attempt to pay in the required amount of estimated taxes or withholding, so you do not have an underpayment penalty. That’s very tricky, because your final decision will be based on the investment experience. If all your conversions gain enough so that you do not want to recharacterize them, then I guess an underpayment penalty would be worth it.
This strategy is not foolproof by any means because the market could do some crazy things right after the recharacterization deadline, and then the hindsight does not look so brilliant.
Permalink Submitted by Jared Graupmann on Wed, 2008-11-05 02:01
Thanks for all the info. My total Roth is now 13.9k, so in essence, I would be recharacterizing multiple years of conversions bringing my Roth down to $300 just to avoid paying the extra 13k this year? This then means that last year’s $12k conversion was in vain?
If I am correct (above), is recharacterizing in my best interest? It doesn’t make sense to me that I would end up converting many assets twice from TIRA to Roth since I’d now be sending last years conversion back into the TIRA along with the assets I converted earlier this year.
How would this have played out differently had I converted each asset into it’s own Roth? Would it do me any good to split all my Roth assets into individual Roth accounts before proceeding with any of this?
Permalink Submitted by Alan Spross on Wed, 2008-11-05 04:51
I don’t think that your numbers correctly reflect the Pub 590 worksheet. To do a full recharacterization, you need the correct opening value on line 3. That includes the amount of your conversion. Isn’t Fidelity willing to do the calculation for you? Most IRA custodians will.
The result is that far less than the 13.6k converted will go back to the TIRA, so your Roth balance may only sink by about half the converted amount. To wipe out the tax bill for the 13.6 conversion, only the reduced amount has to go back to the TIRA, not the full 13.6k.
You should recharacterize that conversion, but wiping out the conversion is better than paying the tax on phantom values that no longer exist. The recharacterization will leave you in the same position you would have been if you had not converted, ie your loss will be in the TIRA, not in the Roth. That said, your pre existing Roth also took losses, but that would also have happened without the conversion.
The only reason NOT to recharacterize would be if you were able to convert with a very low or almost no tax bill for it. That would be quite rate, and is probably not your situation.
There is no reason to partition your Roth accounts at this time. If you had converted to a separate Roth, the earnings calculation would have been different, and a different amount would be recharacterized, but that cannot be accomplished after the fact. Try to get Fidelity to give you the figure, and you might try to complete the worksheet to see if you agree with their figure. They should certainly have software that does this for them, and by now are probably used to negative earnings results.
Permalink Submitted by Billy Anderson on Wed, 2008-11-05 17:09
I have found the “Earnings Calculation for Returned or Recharacterized IRA Contributions” publication by the Department of Treasury at http://www.irs.gov/pub/irs-regs/td9056.pdf to provide very helpful information and examples of the recharacterization calculation process.
Also, it has been my experience that when wanting to get the entire ROTH conversion recharacterized the custodian essentially has to make the calculation, because you have to know the exact balance of the IRA from which funds are being transferred at the time of the transfer, and I never have that information at the time I make the request.