Roth Recharacterization Question

Submitted by Thomas MacDonnell on Thu, 2016-01-14 20:12

I have a Roth Recharacterization Question that is a bit complicated.

The asset that we wish to recharacterize was originally converted from a traditional IRA in April of 2015 when it was valued at $67,500 (Asset A). Simultaneously to the conversion, another Roth Asset (Asset B) that was valued at $50,000 was transferred into the same new Roth account from a different Roth IRA account. On April 29th, 2015 both assets transferred into a new Roth account, which had never had any prior assets before being established in April of 2015.

Security A was valued at $67,500 when it was converted from a traditional IRA to a Roth IRA in April of 2015.
However, Security A is now valued at $22,797.85. Since the conversion, Security A has produced cash distributions which have been reinvested into three mutual funds which are worth approximately $8,842.51, for a total value of $31,640.36 (22,797.85 + 8,82.51).

We would like to recharacterize Security A and presume that we need to recharacterize the three mutual funds as well. We are thinking that we should transfer Security B into a separate Roth account, (perhaps back into the Roth account from which it originally came).

Please let us know your thoughts regarding recharacterization, specifically whether separating the two main assets that are in the current roth account (and the reinvested distributions) is a compliant and sound strategy to avoid apportionment.



Submitted by Alan - IRA critic on Thu, 2016-01-14 20:45

  • In recharacterization you always have to think in terms of dollars first and once the custodian does the earnings calculation to determine the dollar value that must be transferred back to the TIRA, then you should have a chance to select which investments you want transferred to equal that dollar amount.
  • Since you combined the conversion with other Roth assets transferred in, the earnings calculation compares your opening balance (117,500) with your closing balance which you did not indicate, but if we assume that the 50,000 did not change, your closing balance would be 81,640. The loss is about 30.5%. Therefore, if you want to recharacterize the full amount of the 67,500 conversion, the amount transferred back to the TIRA would be around 46,900. Now you get to select whicn investments you want transferred that equals 46,900 at the time of the recharacterization. If you want to transfer A and the mutual funds all worth 31,640, you fall short of the 46,900 figure so you will have to use some of the 50,000 in other assets to get the total transfer up to the required amount. When you select the investments to transfer you would tell the custodian that you first want the investments applied in the following order until the required amount is reached: A, then mutual funds, then the other investments. You do not have to use any of A if you do not want to since the 46,900 could be met with just the original 50,000 investment assuming that the value did not change.
  • Further, due to changed custodian from the original, that custodian will need you help to supply the adjusted opening balance because the new custodian does not know that. Once you give them the figure of 117,500 they can do the earnings calc to determine the amount that must transfer back to the TIRA.
  • If you had converted to a new Roth account that held no other assets, the recharacterization would not even need a calculation. The entire Roth account would be transferred to the TIRA. But since that other 50,000 was included in the same Roth account, it will also have to be included in the calculation.
  • One other point. If you added the 50,000 even one day later after the conversion, the math changes because the 50,000 is not really part of your opening balance as it was added later. That can change the math according to the IRS rules for calculating the earnings. Here is a user friendly description of the earnings calculation: http://retirementdictionary.com/definitions/netincomeattributablenia

 

Submitted by Thomas MacDonnell on Thu, 2016-01-14 23:22

We have used the same custodian for the TIRA and both of Roth IRAs. Not sure why we can’t simply put asset B back into the Roth from which it came and then do the recharacterization of Asset A, which is the only asset that was converted.Asset B has not changed in value.  It is a non-traded private placement real estate partnership. 

Submitted by David Mertz on Fri, 2016-01-15 00:18

  • Unless the transfer was done first and changed value before the conversion was performed, the Adjusted Opening Balance in the loss calculation would be the same regardless of the order of the conversion and the transfer transactions.  If the transfer was done after the conversion, the amount transferred in gets added to the amount converted in determining the Adjusted Opening Balance.
  • The gain/loss calculation must take into account the overall investment performance of the account, not just the performance of a single investment within the account.  Transferring an amount out of the account doesn’t help since any amount transferred out must be added back to determine the Adjusted Closing Balance used in the calculation.

Submitted by Alan - IRA critic on Fri, 2016-01-15 00:52

  • If you read the link I posted, you can see how interim transfers (in or out) of the Roth being recharacterized alter the opening value or adjusted closing value. So if you transfer B back to it’s original Roth account, the 50k must be added to the adjusted closing balance. A higher closing value means your % loss is less in the conversion account and a lower loss means that a higher amount transfers back to the TIRA. However, since A and the mutual funds are not worth nearly enough to meet the dollar requirement but are all that is left in the conversion Roth, there will be less dollars transferred to the TIRA than the calculation generates and more dollars left in your combined Roth. This last proposed transfer therefore results in a manipulation of the recharacterization process much to your favor. Essentially it produces a reduced recharacterization amount equal to what would have happened if the conversion Roth never held anything but Asset A. Some IRA custodians such as Vanguard have in the past looked through these transfers and included the other Roth IRA balance in the recharacterization calculation, but most are probably not smart enough. With any complex recharacterization affected by transfers in or out of the account being recharacterized it is often tough to determine how the custodian intends to handle it in advance. SInce your custodian holds all these accounts, the paper trail is there for them to incorporate these transfers as they see fit – or however their software program was programmed.
  • As a side note, due to Asset B you may be using a self directed IRA custodian. All custodians are required to determine the year end value of all their IRA holdings and if they cannot determine this from their own sources they may opt to request assistance from the IRA owner.  Since 2015 just ended, they may or may not be in the middle of this process now as it comes with the territory for a self directed IRA custodian, regardless of which IRA account holds the investment. This obviously adds another variable to the complexity of the recharacterization procedure.

Submitted by David Mertz on Fri, 2016-01-15 01:19

The required adding back of the amount transferred out of this account prior to the recharacterization simply restores the Adjusted Closing Balance to what it would have been had the amount not been transferred out.  Therefore, the % gain or loss adjustment used to determine the amount that must be transferred in a recharacterization is the same with or without a transfer out before the recharacterization.

Submitted by Alan - IRA critic on Fri, 2016-01-15 03:18

DMx – true with respect to the calculations, but doing the transfer out before the recharacterization results in the conversion account balance being too low to satisfy the NIA calculation results. However IRS Reg 1.408-11 states that both the computation and the distribution are limited to the IRA that received the contribution being recharacterized. This has created an opportunity for some taxpayers to game the system.  Including the adjusted transfers in the calculation, but then allowing the Roth assets in the conversion account to be transferred out to another Roth account compromises the intent of these Regs.

Submitted by David Mertz on Fri, 2016-01-15 15:56

  • We’ve had this discussion before.  I maintain that if, due to distributions or transfers out of the account, the balance in the account in question is less than the amount needed to satisfy a recharacterization of the full amount (including the transfer of the required gain or loss), only a partial recharacterization from that account is permissible.
  • As you suggested, it might be possible to treat the account in question and the account to which an amout was transferred as a single account when performing the calculations.  Effectively, some of the money transferred to receiving account was attributable to a portion of the conversion and associated earnings.
  • The IRS created ambiguities when they decided to do the calculation on a per account basis.  Had the IRS stated that the earnings calculation must be done across all like IRA accounts (similar to basis calculations), no such ambiguities would exist.  However, that would mean that the IRA owner would have to calculate the earnings, something that most owners would have difficulty doing (which is likely the reason the went with the per-account approach).

Submitted by Thomas MacDonnell on Fri, 2016-01-15 22:35

Its appears that the proper thing to do is to recharcterization all of Asset A, plus A’s reinvested distributions and a portion of Asset B to make a total recharacetizaion of $46,900.  That seems fairly straight forward.  Then, after waiting 30 days, we could reconvert the very same assets, correct?  The whole point of this is to save taxes on the difference between Asset A’s origingal conversion amount of $67,500  and the prorata recharacerization amount of $46,900.  I estimate the tax savings at $6,180 ($20,600 * 30% = $6,180).  1.  Please confirm if you agree.2.  Also, if Asset A produces anymore distributions before recharacetization, then the loss would be less and the eventual tax savings would be reduced as well.3.  When the second conversion is done, is there any restriction on how much has to be converted?

Submitted by Thomas MacDonnell on Thu, 2016-01-21 22:56

Remember, my client has two just assets in one of his Roth Accounts.Asset A was a TIRA asset that was converted to a Roth in 2015.It was converted at $67,500 and is now worth $31,640.36.We would like to recharacetize this Asset, because it could save taxes.However there is another asset in the account, Asset B, which was always a Roth Asset.The source funds for Asset B goes back more than 5 years.Asset B is valued at $50,000 and was invested April of 2014 at that same amount, $50,000.My question is this:  Since Asset B is past its recharacterization time limit of October 15th of 2015,then shouldn’t it’s value be disqualified from the recharacterization formula?   If so, then there is no need to transfer Asset B out of the Roth after-all.Ultimtely, I will consult with Pershing to see how they will handle it.What do you think now? 

Submitted by Alan - IRA critic on Fri, 2016-01-22 01:10

  • IRS Regs state that only the IRA account that held the conversion is included in the earnings calculation. All assets in the account with various gains or losses are included and the result is an overall % gain or loss which determines the value that is transferred back to the TIRA account. The IRS only cares that this value is transferred and does not care which assets are actually transferred in the process. In other words, once the dollar value is determined, then the Roth owner can elect to fill that value with any asset he wants.
  • Now if certain transfers between different Roth accounts were done during the time of the conversion, the original account value can be vastly changed in a way that the earnings calculation could be skewed. Some custodians will then attempt to include more than the original account in the calculation to arrive at a more equitable result. In your latest post you did not mention any transfers, and I did not review all prior posts in this thread, but if the conversion of 67.5k into a Roth already holding B at a constant value of 50k was done and there were no interim transfers in or out of the Roth, there will be a loss of roughly 35k from an opening balance of 117.5k which is about 30%. To recharacterize the 67.5 conversion, a transfer of around 47k will have to be sent back to the TIRA. Since A is now worth only 32k, then shares of B are all that is left to make up the remaining 15k to complete the recharacterization. Again, ANY assets in the Roth are subject to transfer, as the entire process is driven by dollar value and not be specific assets. In fact, B is worth enough itself to satisfy the recharacterization amount and all shares of A could be left in the Roth. All the IRS cares about is that any asset  or combination of assets worth 47k are transferred to the TIRA to complete the recharacterization. That will eliminate the tax bill for the original conversion. I expect Pershing will agree, although they may explain it differently.

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