Roth Conversion & Recharacterization
My client attended an advisor seminar. The pitch was to split a traditional IRA into 10 separate accounts and then covert the 10 separate accounts to Roth IRAs. If they appreciate in value before 10/15/2011 then you recharacterize enough of them to equal the market value of the total accounts at the date of the coversion. They claim by recharacterising the Roths back to regular IRAs at the conversion date market value will allow for no taxation on the remaining coverted Roth IRAs. In essence the market value increase remains in the converted Roth IRAs tax free. Example: $100,000 traditional IRA is first split in 10 $10,000 IRAs. All 10 IRAs are converted into $10,000 Roth IRAs. At October 1, 2011 the value of all 10 Roth IRAs is now $110,000. You find 8 of the Roth IRAs that equal $100,000 and recharacterize them back to regular IRAs by October 15, 2011. The advisors claim the $10,000 of value in the 2 remaining Roths will not be subject to tax since the $100,000 market value was recharacterized. I believe the 2 converted Roth IRAs are still subject to tax on the value at the date of conversion since they still exist as converted Roth IRAs. Your thoughts are appreciated.
Permalink Submitted by Anonymous (not verified) on Wed, 2010-06-23 22:08
My first thought is that if these investments “stop” (are sold to cash, for example) at that point you gain an advantage. What if the 8 investments that lost in this time period, rebound dramatically 1-2 years later? And you have to wait 30 days to reconvert. There seem so many unkowns with respect to the vehicle’s performance. Doesn’t this just give you a “preceived” advantage?
pko
Permalink Submitted by Alan Spross on Wed, 2010-06-23 22:42
More simply, the advisor stategy is based on a totally incorrect presumption that some sort of aggregation rules apply to recharacterizations. Rather, each specific conversion is totally isolated for recharacterization purposes. Any of these conversions that is not fully recharacterized will be taxable. The taxable amount of a Roth conversion has absolutely nothing to do with the value of the conversion at the recharacterization date.
Really, the only way to actually have a tax free conversion is to have 100% basis per Form 8606.
Looking at this “stRATegy) further, it probably arises from a lack of understanding of the Roth IRA recharacterization rules. However, if this advisor is also counseling on how to report these conversions and recharacterizations on the tax return in such a way to camouflage the amount recharacterized, then he is advocating tax fraud. For example, there will obviously be a 1099R for 100,000 and therefore they would have to represent partial recharacterizations as full recharacterizations to erase the 100,000 on the 1099R. That would be tax fraud. In addition, the IRS will receive a 5498 on every Roth IRA account showing the year end value of every Roth account. If that value rises after a full recharacterization of the account, then something is obviously haywire.
You are correct that any Roth IRA accounts not recharacterized would still be taxable. Probably the best strategy and it is totally in compliance with current IRS Regs. is to just do the multiple conversions and recharacterize the worst ones, leaving the gainers in place. There will still be taxable income in the current year (or 2011/2012), but the Roth values will be higher for the ones that remain. This is where pko’s comments apply. That snapshot in 10/2011 still amounts to a paper gain that could totally disappear like they did in 2008, UNLESS the investments were sold in the Roth and replaced with stable value investments such as CDs or MM funds.
Permalink Submitted by Anonymous (not verified) on Thu, 2010-06-24 06:09
alan:
I kind of assumed from the post that the accounts were going to be separate all throughout and the purpose was to “weed” out the good and bad investments.
Now, if one was really disciplined, maybe this strategy would work for highly volatile investments that are strictly bought and sold in the timeframe perscribed. And the investor did this every tax year. I realize this is a stretch, but I am trying to see something positive…..
pko
Permalink Submitted by George W Smith IV on Thu, 2010-06-24 12:00
Alan:
I agree with your analysis completely. The advisors don’t seem to understand the recharacterization rules at all. They made it clear several of their clients are already taking this approach. I believe they are in for a rude awakening.
George
Permalink Submitted by Joseph Arsenault on Thu, 2010-06-24 19:32
There trying to play roulette without knowing the rules. Have seen the same thing. This idea that this would pull off an almost free conversion would require an investment vehicle that does not exist! Its like putting one chip on every roulette number, you hit one and keep it, you recharacterize the rest. You get a payout equaling the original conversion amount, but only pay tax on a sliver of the amount (the bet). Theory works, application not so much. I agree with you guys.
Permalink Submitted by Bruce Steiner on Thu, 2010-06-24 22:33
If not for the green 0 and 00 on the roulette wheel, you could divide your IRA into two separate IRAs, convert them to Roth IRAs, invest one on red and the other on black, keep the one that won, and recharacterize the one that lost.
Permalink Submitted by Joseph Arsenault on Thu, 2010-06-24 23:59
Ha, stupid 0’s.. Would be a beautiful thing though if viable.