Did I shoot myself in the foot??
My situation is this: I am 73 — have multiple IRA’s developed over the years and the attraction, this year, of converting one of the non-Roth IRA’s to a Roth IRA was compelling to us. In February we transferred shares of stock from one of our traditional IRA’s to the newly established Roth IRA. Face value of the equities at the time of transfer was approximately $250,000. In May we sold $104,000 worth of one of the equities in the newly formed Roth and used the money for family needs. Subsequently, we have thought of recharacterizing the newly formed Roth back to the traditional IRA. However, the present value of the Roth is only about $175,000 and this presents my first dilema: is there any way to replenish the newly formed Roth back to it’s original value when it was created by transferring money from my Trust account (non-IRA) or from one of my other IRA’s we own, i.e., increase the value from the $175,000 back to the $250,000? Secondly, the $104,000 will probably be taxed as a withdrawal from the Roth and hit me with a sizeable penalty. Not good!!
Any suggestions as to what to do next will be greatly appreciated. Whether to recharacterize the Roth IRA or not? I do have money outside the IRA’s to pay the taxes with if that is what has to be done. Sorry for the long unwrapping of my situation.
Permalink Submitted by Alan Spross on Tue, 2010-12-28 01:50
Well, I will say that this is the first post where a distribution was taken from a contribution prior to a recharacterization request. The IRS does not appear to have published in their Regs how this situation could be handled, but there is only one approach that seems to make sense.
Before I get into that, why do you want to recharacterize the amount of your conversion that remains? It appears that you have a gain following the conversion since the amount you took out plus the amount left in the Roth exceeds the 250k value you converted.
Another situation you must face here is that if you planned to report this conversion in 2011 and 2012, your distribution will accelerate the taxes into 2010 to the extent of your distribution. This is not an additional tax, but the taxes are due earlier than otherwise. There are no early withdrawal penalties here since you are over 59.5.
Please advise why you want to recharacterize the portion that is left and also, is this your first Roth IRA account?
Permalink Submitted by Otis Miller on Wed, 2010-12-29 04:38
Thanks for your prompt response to my posting.
Yes this is our first Roth and may be our last. We knew upfront before we set up the Roth that the tax bite will be substantial. As of now, we are just making sure that we fully understand what our options are before we make a wrong move. We are not firmly fixed in recharacterizing the Roth but just want to know the options available to us and what the taxes will be. We are active traders and plan to use the Roth account to increase our overall trust value every year and know that the withdrawals will always be tax free.
But, as I understand, if we do recharacterize the Roth, we still must pay the taxes on the distribution we took in 2010. We just would not have any tax liability in 2011 and 2012 from this transaction I am writing about.
If I understand what you have written, this is how my tax scenario would play out on this situation:
1. I will pay the taxes in 2010 associated with the $100,000 withdrawal regardless of whether I recharacterize or not
2. If I do recharacterize, there are no further taxes in future years related to this event.
3. If I do not recharacterize, then the remaining amount: $250,000 – $100,000 = $150,000 will be taxed equally in my 2011 and 2012 returns
Your comments on this summary will be greatly appreciated.
Permalink Submitted by Alan Spross on Wed, 2010-12-29 18:34
Before addressing your questions, you may have another issue to resolve. Before converting you needed to take your 2010 RMD out, and you did not mention that. If you did not take the RMD, part of your conversion included the RMD which will be covered by your 104k distribution, but needs to be reported correctly.
1) Correct. Instead of reporting income of 125,000 in 2011 and 125,000 in 2012, you will have to report 104,000 in 2010 income, 125,000 in 2011 and the remainder of 21,000 in 2012. Note that this is NOT a tax on your Roth distribution because your distribution is tax free since it came from your conversion which is being taxes as listed above. But you do have to report the Roth distribution on Form 8606, the same form on which you will report the 2010 conversion.
2) Correct. If you recharacterize your remaining conversion funds, you will eliminate the 2011 and 2012 income shown above. You would report a conversion of only 104,000 on Form 8606. The negative of recharacterizing the rest is that your 29,000 of earnings will all end up back in the TIRA and become taxable once you take them out.
3) Covered in 1) above, and not as you stated here.
Permalink Submitted by Otis Miller on Wed, 2010-12-29 21:46
Thank you again for your prompt and precise reply to my situation. Following is more background/question regarding my problem:
1. Yes, I did take my 2010 RMD before I was allowed to establish my Roth.
2. I fully understand the 2010 tax year liablilty for the $104,000 distribution from the Roth. But why isn’t the remaining ($250,000 – $104,000 = $146,000) of $146,000 split between the tax years of 2011 and 2012, i.e,. $73,000 per tax year?
3. One of your comments on your first reply : “The IRS does not appear to have published in their Regs how this situation could be handled, but there is only one approach that seems to make sense.” This is not to question your advice but is my situation a “grey area” in the IRS regulations as I want to feel comfortable with the direction we are headed on this matter. From my limited knowledge of tax issues I feel that I should just go with your advice. This is my first voyage into the inner workings of the IRA world and do not have a good feel for whether I am on “thin ice” or not.
4. Your advice has been greatly appreciated.
Permalink Submitted by Alan Spross on Wed, 2010-12-29 22:29
1) Good that you took your RMD.
2) Congress wrote into the 2010 conversion provisions that distributions from conversions taken in 2010 or 2011 would accelerate the income reporting for the 2010 conversion. The reason for that is they did not want taxpayers deferring their taxes by converting when they actually wanted the money for other purposes. If taxpayers could do that, everyone would convert rather than just taking funds from their traditional IRA to get the two year deferral and then take the distribution from the Roth, as you have done. This also applies to distributions of conversion money from conversions prior to 2010. If a taxpayer waits until Jan, 2012 before taking the distribution, it does not affect when the income is reported, and that is only a year away.
3) You are not on thin ice, and have every right to recharacterize the rest of the amount in the Roth IRA. The 175,000 that remains obviously includes the 29,000 in earnings generated in the Roth, and if you recharacterize the entire amount there will be nothing left in the Roth. You would need to attach an explanatory statement with your return explaining the dates and amounts of the conversion, the distribution and the recharacterization so that the IRS understands what happened. In the end, all you will have taken out is the 104,000 and that is all you will be taxed on.
If you decide to do recharacterize, post back here when you are about to do your return and I will provide the specific wording for the statement. You could give that to your preparer, since very few preparers will have have experience with this combination of events.
One more thing you should know here. Assuming you will not get this recharacterization done this year, your end value of your TIRA will be understated by the amount by the 175,000 that will not be there on 12/31/2010 but will be later on. You would then have to increase the year end balance showing on the Form 5498 to determine your 2011 RMD. This is what is called an “outstanding recharacterization” since you are reversing the rest of the conversion but the funds are not yet back in the TIRA on 12/31. Your 2011 RMD must be figured as if the funds were actually there.