recharacterization
I just read Ed’s Oct newletter and have a question.
Easy scenario 1…. In Oct 2007 I convert 1 share of abc when it was 100,000. In Oct 2008 it’s 30,000 so I re characterize by pulling out my 1 share and putting it back in a tira. I avoid paying tax of 28,000 on a now 30,000 position. Nothing else was in Roth.
Harder scenario 2…. Same thing except the Roth had an existing 1 share of xyz that was vaulued at 100,000 in Oct 2007 and in Oct 2008 is at 150,000 I want to re characterize my abc share so i PULL OUT MY ABC SHARE and put it back in tira.
Can someone please run me through the averaging calculations that render sceanrio not as good as 1.
Permalink Submitted by Alan Spross on Fri, 2008-11-14 04:38
Chuck,
Actually, you are recharacterizing amounts, not shares. The mix of investments you use is up to you. Of course, in many cases the holdings in the Roth have totally changed by the time the recharacterization decision is made.
In Scenario 1 the earnings calculation is evident and requires no calculation since there was only one holding in the Roth the entire time. The loss was 70,000.
In Scenario 2, the total experience of the Roth account must be considered. There is a gain of 50,000 netted with the loss of 70,000 for a net loss of 20,000. This loss of 20,000 occurred to an original value of 200,000 , ie a loss of 10%. The amount that must be recharacterized is 90% of the 100,000 conversion or 90,000. You get to select how to split the holdings to produce a transfer of 90,000 back to the TIRA.
If you recharacterize all the abc, that’s only 30,000 and you must come up with the other 60,000 from xyz. Of course with only one share, you must sell the stock, so let’s assume it’s 100 shares. Since 60,000 is the amount you need, you would transfer 40 shares or 40% of the 150,000 to make your total recharacterization 90,000.
You could also recharacterize no abc and 60% of xyz to get to the 90,000. The ONLY requirement is that the value that goes back to the TIRA is 90,000. It can be composed of anything you wish including a MM fund if you sold the shares in the Roth.
Note that both of these recharacterization scenarios results in the same elimination of your tax bill on the 100,000 conversion. But with Scenario 1, your Roth balance is -0-, and with #2, your Roth balance is 90,000, only 10,000 less than what you started with.
In fact, with Scenario #2, you may not even want to bother with the recharacterization. What turns out to be not as good as with #2 is that by commingling the conversion you had to send 90,000 out of your Roth to offset the tax bill vrs 30,000 if the conversion had been into a new account. Your Roth balance would then end up a -0- for the Roth holding abc, but the 150,000 in the Roth with xyz would be intact.
In summary, the combined Roth ended up by fouling up the big gain you had in xyz. You still got the gross gain, but some of it ended up back in a TIRA to become taxable at some future date.
You may have noticed some prior posts where the IRA custodian told the taxpayer that to complete a recharacterization they were going to have to send additional assets back to a TIRA. There is more control if conversions are made to new Roths rather to existing ones.
If you reverse your example in the combined account and the existing investment lost and the converted investment gained, you would probably not recharacterize because you would have a net gain and even more would have to go back to the TIRA, more than the 100,000 that was converted.
Permalink Submitted by charles lore on Sat, 2008-11-15 15:22
Allan thank you but 1 question. Can I , for whatever reason, characterize part of the original conversion..say 50,000? Would there be any sound reason for doing so?
Permalink Submitted by Alan Spross on Sat, 2008-11-15 19:41
Definitely, you can recharacterize part of a conversion, or if you have more than one conversion in a year, you can treat them totally separately, recharacterizing each one either totally, partially, or not at all. Again, the holdings you choose to move back to the TIRA can be anything that is currently in the account that you are recharacterizing from, and do not have to be the holdings that you converted.
Those who do not qualify for conversions due to income must of course do full recharacterizations. But some people want to convert early in the year and have no idea how their tax picture will turn out. For example, someone migth convert 50,000 and in the following March discover that they are 20,000 into the next highest tax bracket. They might choose to recharacterize that 20,000 so that they do not pay that higher rate at all.
Another person might do two conversions with the intent to keep the best perfomer and recharacterize the other. If they kept them both, they might enter a higher bracket, BUT if their earnings were good enough, it might be worth it. If one conversion gained 50% and another 30%, they might decide it is worth paying a higher rate for that amount of potentially tax free gain, and keep both conversions. Of course, gains seem a distant memory now that we have major losses in most cases and I imagine there will quite a few last minute recharacterizations done near the October 15th deadline for 2007.