If you made a Roth IRA conversion in 2010 and the investment has declined in value, you should consider undoing or, as it is technically referred to, recharacterizing your 2010 Roth conversion. The recharacterization returns your Roth IRA to a traditional IRA, with no penalties.
The deadline for recharacterizing your 2010 Roth IRA conversion is October 17, 2011.
Recharacterizing a Roth IRA
A partial conversion of your IRA to a Roth is frequently a good idea, but that assumes your investment makes money. If the underlying investment loses money, however, especially as much as 20% in one year, at least in the short run the Roth IRA conversion will hurt you, not help you.
The income you must recognize from a Roth IRA conversion is usually determined by the fair market value of the portion of your IRA that you convert to a Roth IRA on the day you make the conversion. That income is added to your existing income which in turn increases your tax liability. For example and to oversimplify a bit, if your taxable income before the conversion was $60,000 and you made a $100,000 Roth IRA conversion in 2010, your taxable income for 2010 would be $160,000. (I will get to the income spread over 2011 and 2012 later).
If the value of the investment drops from $100,000 to $80,000, then the upshot is, you must recognize $100,000 worth of income for a $80,000 Roth IRA. Not a good deal.
What should you do? If you are facing a substantial loss, you should consider a recharacterization, because then you will not have to recognize the additional $100,000 in income. When the Roth IRA is recharacterized (returned to a traditional IRA), your tax situation will be as if you had never made the conversion. You must realize, of course, that the value of your new traditional IRA will be $80,000 not your original $100,000, but that market loss would likely have been reflected in the value of your original traditional IRA.
Is Recharacterizing Worth the Aggravation
You may be asking “How do I know if my loss is ‘substantial’ and worth the additional paper work and aggravation?” The answer, of course, is: it depends. Some people would not want the aggravation no matter how much money in taxes the recharacterization saves. There is no clear-cut answer because it depends on how you value your time and your long-term investment strategy. But let’s look at a simple example.
If the investment goes down by $20,000, and the tax on the $20,000 is $5,000, depending on how you value your time and hate aggravation, the $5,000 savings may tip the balance in favor of some aggravation and even some professional fees if you need some help with the recharacterization. If, however, an additional $5,000 in taxes does not seem worth it over the long haul, and this would be particularly true if the conversion was part of a multi-year Roth IRA conversion plan, then you might choose to simply let the loss slide.
Keep in Mind Effects of Changes in Tax Rates between Years
Sometimes recharacterizing and reconverting may not be worth it at all. A simple example is one where you found yourself in a zero tax bracket in 2010 so you converted some of your IRA to Roth at no tax cost at all. In that case, it is not necessary to recharacterize and reconvert. A slightly more realistic and more common example may be where you found yourself in the 15% tax bracket in 2010 but will be in the 25% or higher tax bracket in the future. This might occur after retirement and before your pension income starts. In this case, your tax rate is 40% less in 2010 so recharacterizing and reconverting it when your Roth IRA went down only 20% is not beneficial to you. For example, tax on the original conversion of, say $20,000 in 2010 would be $3,000, and if it goes down 20% to a value of $16,000, tax on a 2011 conversion of that amount would be $4,000, which is more than the original conversion tax in 2010. In that case, it is not advisable to recharacterize and reconvert.
Some Nitty-Gritty Recharacterization Mechanics for Filing your Tax Return
Our usual recommendation for people who made a 2010 conversion was to extend your tax return filing date until October 17, 2011. Under those circumstances, you can complete the appropriate paperwork for recharacterizing when you make that filing. If you have already filed your 2010 return, you will need to file an amended tax return, Form 1040X, to reflect the new Roth status. If you did not file for an extension and filed your return on time, you can still do the recharacterization and file an amended return (write “Filed Pursuant to Section 301.9100-2” on the top of the amended return).
More Nitty-Gritty Rules for 2010 Conversions and a Simple Example
2010 was a special year because you could elect to recognize half the income on the conversion in 2011 and half in 2012, or you could elect to recognize all the income in 2010. Since the 2010 tax rates have been extended to 2012, however, spreading the income over two years makes some sense in terms of income tax deferral. So, here’s an example of a strategy you could pursue. Let’s assume you converted $100,000 in 2010 and that your plan was to recognize half the income in 2011 and half in 2012. But then the investment lost money and it now stands at $80,000. So, you decide to recharacterize your 2010 conversion, and now you have an $80,000 traditional IRA again. You wait at least 30 days, as that is mandatory before converting the same money to a Roth again, and then you make a $50,000 conversion in 2011 and another $50,000 conversion in 2012. Let’s assume the market is flat from now till the end of 2012. The result, is a Roth of $100,000 instead of $80,000 for the same tax cost.
Should You Make Another Conversion?
It is likely a good plan to recharacterize if you suffered a major loss. But then, it is also a good idea to take your lead from the example above, and either reconvert that same money to a Roth IRA (after 30 days) or convert a different IRA to a Roth.
Convert, Recharacterize, and Reconvert
There are a few hurdles you must jump to come out ahead if you want to reconvert that same money back to a Roth after recharacterizing to a regular IRA. One problem is that you cannot re-convert the same money without waiting 30 days. Nobody knows what the stock market will do in that 30 day period. That means you have to re-examine the situation in another 30 days. I must point out here that you are also required to wait until the following tax year to reconvert the same money. But, for 2010 conversions, it already is the following tax year, so that is not a problem.
If you choose to reconvert the same amount as your 2010 recharacterized Roth IRA (i.e., your new $80,000 traditional IRA) is worth now, all the taxable income must be reported on your 2011 tax return. The option to report half in 2011 and half in 2012 is not available. Although not as advantageous, it may still make sense to do the recharacterization if the tax rates are the same. However, including all the taxable income in 2011 may push you into a higher marginal tax rate. This would reduce your tax savings to some extent, possibly entirely eliminating it.
There is no easy advice that will work in all circumstances. What I am trying to do in this article is present the relevant information so you can look at the issue of recharacterizing on your own, be alerted to the situation and seek professional help, or just disregard it because it isn’t worth the aggravation.
Recharacterizing 2011 Conversions
If you made a conversion in 2011 and the underlying investment declined, you could use a similar, but slightly different strategy. Since we are in 2011 now, the general recommendations made in The Roth Revolution, Pay Taxes Once and Never Again, would apply. To summarize the recommendations in the book:
Assuming you have additional pre-tax IRAs or retirement funds that can be converted to a new Roth IRA, you convert those funds in the same amount that you originally converted to create a new Roth IRA. Then, ultimately (you will have until October 15, 2012 to decide) you go through the process of recharacterizing the 2011 Roth that declined in value. That way, you are not reusing the money from the original conversion and you can get around the thirty day waiting period, and the “not in the same year” rule.
For example, let’s assume you converted $100,000 in 2011. Now that Roth is worth $80,000. We recommend you consider converting a different IRA for $100,000. You will have until October 15, 2012 to recharacterize either Roth IRA conversion. Let’s assume the market stays flat. Then, sometime before October 15, 2012 you recharacterize the losing Roth that is now valued at $80,000 and keep the second Roth IRA that is worth $100,000.
However if you don’t have other funds to convert to a new Roth, just know that if you recharacterize your declined value 2011 Roth, you cannot reconvert that money until January 2012.
In the Final Analysis…
So, should you recharacterize your 2010 conversion? The correct answer without knowing your particular situation and without being able to predict the future growth of your Roth account is: maybe. It certainly makes sense to see where your 2010 Roth IRA conversion value stands right now – not last month. The stock market has been changing quickly. And if a recharacterization is appropriate, then prepare to make the recharacterization quickly.
If you are also planning to do another Roth conversion in 2011, or 2011 and 2012, to replace the recharacterized Roth conversion, it ideally should be done when the market is down so that you achieve the planned tax savings. If you wait until the market goes back up before you reconvert, you will lose your planned tax savings. One problem, of course, is they don’t ring a bell when the market bottoms out.
In some cases a recharacterization can be done quickly online, but in other cases it can take some time to process the paperwork to accomplish a recharacterization. Do not wait until the last day if possible, since the October 17, 2011 is the firm deadline for recharacterizations.
Resources for Additional Information and Help
Free: Go to www.retirementpittsburgh.com. There are quite a few articles on Roth IRA conversions and recharacterizations.
Free: Go to http://paytaxeslater.com/radio-show/ and listen to Episode 24 with Barry Picker.
Cheap Resources: My book, The Roth Revolution, Pay Taxes Once and Never Again. This can be found on www.amazon.com and has an abundance of Roth IRA conversion information, including a discussion of recharacterization.
Other Resources: If you are interested in getting help from our office on this issue, please call. For existing clients, we will certainly try to accommodate your request, and for new clients, we will do what we can to help as time permits.