Be Wary of Recharacterization Calculations by Custodians
Be wary of letting custodians do the calculation of the recharacterization amount. I had a client who made a $25,000 Roth Conversion in April 2008. By the end of October 2008, the value of his Roth IRA (including the converted amount) had plummeted 40%. So, we decided to recharacterize since it made no sense to pay taxes on $25,000 to wind up with $15,000 in the Roth IRA. The client submitted the request to the custodian who processed the recharacterization at the end of October. He received a 1099 stating that the amount of the recharacterization was over $33,000.
When we called the custodian, they agreed with us – in theory – that it made no sense that the amount recharacterized would be greater than the converted amount when the Roth IRA dropped 40% in value between the conversion date and the recharacterization date. However, they stated that their software was infallable and refused to discuss the matter further.
Finally, after much arm twisting, they agreed to go back and adjust the amount recharacterized if we provided the amount to be recharacterized. I completed the worksheet from the IRS Publication after checking my calculation (which is actually quite simple) and gave them the appropriate amount of $15,000.
I was amazed at the arrogance of the custodian not allowing for the possibility that their software might have a glitch. I fear for how many other folks may be letting this custodian calculate the recharacterization amount incorrectly and – as a result – are recharacterizing too much money back to the Traditional IRA where the excess recharacterization will be subject to taxation a second time.
Permalink Submitted by Alan Spross on Sat, 2009-03-07 23:32
While this was the most egregious situation I have heard of, this is indeed a concern when a record number of recharacterizations are being done this year to avoid the tax bill on conversion assets that are now depleted. It also illustrates the advantage of making each conversion of any size into a new Roth account, since it avoids a calculation altogether. A full recharacterization would return the entire account, and a partial would return the exact % of the account balance. Of course, this involves some extra work in opening a new account, and with several accounts that may be consolidated, recharacterized etc, we know that beneficiary designations have also been known to disappear or be overlooked altogether.
I would advise that Roth owners do their own calculation of earnings prior to ordering the recharacterization and tell the custodian not to complete it if their calculation produces a figure more than x% above the provided figure. In figuring the “x” keep in mind that the markets have been changing (ie dropping) up to 5% in a day.
Also, note that the account platform some custodians use can result in having to include more than the account holding the conversion. There has been reports of this being a problem with Vanguard, likely caused by their setup for the sweep account. Hopefully, they are fixing this.