Disclaimer: Please note that the Tax Cuts and Jobs Act of 2017 removed the ability for taxpayers to do any “recharacterizations” of Roth IRA conversions after 12/31/2017. The material below was created and published prior the passage of the Tax Cuts and Jobs Act of 2017.
Uncertainty and volatility in the market create both problems and opportunities for IRA owners who desire to convert either a portion of, or their entire IRA, to a Roth IRA.
Nevertheless, we stand by our conviction that many IRA owners would benefit from a Roth IRA conversion if the income taxes on the conversion can be paid with funds outside of the IRA. By implementing the aggressive strategy outlined in this article, you may be able to “hedge your bets” to take the full advantage of a Roth IRA conversion while reducing the risk of a downturn in the market after making a Roth IRA conversion.
This article addresses the important question, “Which assets should the IRA owner convert?” For more detailed discussions of the benefits of a Roth IRA conversion and answers to the questions of how much and when to make a Roth IRA conversion, I recommend the following articles: IRAs After the TRA 97 – What Hath Congress Roth?1 and The Roth’s Real Advantage
The ability to “unconvert” or reverse a Roth IRA conversion provides the key to identifying which IRA assets you might opt to convert to a Roth and the key to saving taxes. Technically, the correct term is to “recharacterize” a Roth IRA back to a traditional IRA.2
First we need to understand the regulations governing recharacterizations. Then we will provide several examples of situations that can take advantage of those regulations.
Rules Governing Recharacterizations
The IRS permits IRA owners to recharacterize Roth IRA contributions from one type of IRA (i.e. Roth or traditional) to the other. This applies to both the ordinary annual contributions and the conversion contributions. The deadline for recharacterizing a contribution or conversion is the extended due date of your tax return for the year of contribution or conversion.3 This would normally be April 15 following the year of contribution or conversion, or October 15, of this subsequent year if you have filed for and obtained an extension.
There are also rules limiting the frequency of conversions, recharacterizations, and reconversions. You may not make a Roth conversion, “unconvert” it and reconvert the same IRA money in the same year.4 Even if you straddle different calendar years, you must still wait 30 days before reconverting a Roth IRA that you had previously converted and “unconverted.” 5
Procedure for Recharacterizing a Converted Roth IRA Back to a Traditional IRA
Notify the Trustees of both IRAs involved on or before the transfer date that you want to “unconvert” or recharacterize a particular Roth IRA as a traditional IRA. If the person making the conversion dies before notifying the Trustees, the executor, administrator, or other person responsible for filing the decedent’s final tax return can notify them.6 The notification must contain the following information:
- the type and amount of the conversion to the Roth IRA to be recharacterized;
- the date on which the conversion was made and the tax year for which it was made;
- a direction to the trustee to transfer, in a trustee-to-trustee transfer, the amount of the conversion and any net income allocable to it to the trustee of the recipient IRA; and
- any additional information needed to make the transfer, including the names of the trustees involved.7
If both of your IRAs are maintained by the same trustee, simply redesignating the first IRA as the second IRA will be treated as a trustee-to-trustee transfer.8 You must also report the recharacterization on the tax return for the tax year in which you made the original Roth conversion.9
Note that once the recharacterization has taken place, it is irrevocable. Although you can reconvert the same money if you wait at least 30 days and at least until the next year, you cannot “undo” a recharacterization that has been completed. Therefore, you much use caution when deciding that a recharacterization is the best strategy for you.
Multiple Roth Conversions and Recharacterizations
The rules allow more than one Roth conversion to be made in a single year as long as the money used does not come from a recharacterization. For example, if you want to convert $100,000, you could do it in one single transaction, or you could do five separate $20,000 conversions. The rules allowing recharacterization of conversions apply to each individual Roth IRA separately. So if you did five separate conversions, you could then choose to recharacterize a subset of the conversions.
If multiple conversions are made, they could either be done into one receiving Roth IRA account or into new and separate Roth IRA accounts. Assuming the same beneficiaries are used on all the accounts, multiple accounts would have the same effect as using a single Roth IRA account, except for the result of any recharacterizations.
The recharacterization transfer amount includes any investment income or loss generated in the Roth account after the conversion. In the case of a single Roth account used for five separate $20,000 conversions made at the same time, the recharacterization amount will be the same no matter which conversion is recharacterized. The income allocated to the conversion is based on the performance of the entire account and not individual securities within the account. However, if five separate Roth IRA accounts are used for the conversion and invested differently, the recharacterization amounts will vary based on the different investment returns for each account.
Profiting from the Rules
How do we profit from these rules or, looking at it another way, is there a legal loophole that can save IRA owners money? Let’s look at a case study.
Case Study: Roth IRA Conversion Made in Year One
Suppose you have five separate IRAs of $100,000 each, invested evenly in five asset classes – large cap stocks, small cap stocks, bonds, international stocks, and cash. Any conversions or subsequent unconversions will be made through separate accounts. Let’s assume you have determined that you would benefit from a $100,000 Roth conversion now, during Year One. What are your options?
Option 1: You could make a $100,000 conversion now of any one of the asset classes and hope for an increase in the value of the investment that you choose to convert.
Result: This is a crapshoot. If you convert $100,000, and your investment increases to $200,000 by October 15 of Year Two, you will have a $200,000 Roth IRA for the tax on $100,000 conversion. This is a great deal.
But if your investment declines, it is not a great deal. If you convert an investment that is valued at $100,000, and it drops to $50,000 by the following October, you will be stuck paying income tax on $100,000 and owning a $50,000 Roth IRA.
Therefore, if the investment goes down, you should recharacterize the Roth IRA to avoid the tax on a $100,000 conversion. If you “unconvert” your Roth, you will be in a position similar to where you would have been if you had never made the conversion.
Assuming the traditional IRA would also have declined in value had it been left alone, you will have a $50,000 IRA (and your experimental foray into the Roth environment will have had no tax consequences). Although it is discouraging that your investment went down, it isn’t as bad as if you had had to pay income tax on a $100,000 conversion. After 30 days have elapsed from the unconversion, you could convert the same IRA investment and pay less tax. This strategy, of picking and choosing among the accounts to convert, ends up being a winner if you pick the right asset class to convert.
Option 2: You could make a $100,000 conversion in Year One consisting of one-fifth of each of the five asset class funds and hope for an increase in the value of the investments.
Result: This strategy is an attempt to hedge. This strategy will produce no windfall from overall investment returns, but it is a safer bet because it uses diversification to spread your money around. You may still “unconvert” the funds that break even or lose money, although this will reduce the total conversion amount and possibly not fulfill your original objective of a $100,000 conversion.
Option 3: Don’t make any Roth IRA conversions.
Result: A “do-nothing” strategy misses any opportunity to enjoy the tax-free growth offered by Roth IRA conversions.
Option 4: Thread the loophole. Convert all five traditional $100,000 IRAs to Roth IRAs and be primed to “unconvert” the investments that do the worst from the time of conversion to October 15, of Year Two, assuming a valid extension is obtained.
Result: With perfect hindsight, you “unconvert” $400,000 of your original investments that did not perform as well as the $100,000 that you chose to retain as a Roth IRA. Lucky You can now reap an enormous windfall of tax-free growth in any one of the asset classes that go up in value significantly.
You will still have to pay income tax on the $100,000 income for tax Year One (for the asset class you chose to retain as a Roth). However, the value of the Roth will have increased. Then, possibly within the same family of funds so there are no transaction fees, you can rebalance both your traditional IRA portfolio and your Roth IRA portfolio. The result is that you now have a larger well-diversified Roth IRA.
If your portfolio comprises individual securities, the same principle would apply if separate accounts are used to convert them. You could retain as Roth IRAs the securities that did well and recharacterize the ones that did not, as long as they are converted into separate accounts.
If the future works out differently, you would respond differently. If all the asset classes in separate accounts went down, you could consider recharacterizing all of them and then consider a future conversion based on lower values.
Pitfalls of Option 4
Of course, many people may feel uncomfortable with the “thread the loophole” approach. It may seem like too much of a gamble. There could be “follow through” failures. For example, you might forget to “unconvert,” and that could present a financial disaster. Or you might die and your executor, administrator, or other person responsible for filing the final tax return may not be aware of the plan to “unconvert.”
Another practical problem with the conversion and recharacterization strategy is that it can be a logistical burden. 1099 Forms could be fouled up. You could receive additional attention from our friends at the IRS even if you and the investing company do everything right. Your broker or financial advisor might botch it. They will also likely consider you a pain in the you-know-what for creating extra work for them by opening new accounts. However, this strategy will still appeal to taxpayers who want the most “Bang for their Buck” on Roth conversions, and I have seen it work successfully in the past. For those who are willing to do the legwork to properly implement this strategy, the potential for reward is great.
Time Line for Converting to a Roth IRA and then Recharacterizing Back to a Traditional IRA
What follows is a potential timeline for the conversion and recharacterization process.
Make a conversion before year end. Please note that many brokerage houses need at least a week and sometimes longer to process the paperwork. Therefore, I would consider the practical deadline to be about December 15 of Year One to make the conversion.
As a practical matter, however, for the maximum “look-back” period, you would want to convert at the beginning of the year as opposed to the end of the year. Therefore, if all other factors are the same, you may want to consider waiting from December, for example, until January to make the conversion. This small wait gives you an additional 11 months or so of hindsight.
April 15: File your first extension for your Year One tax return if you want more time to decide on your Year One conversion. As noted above, you can file your return if you are ready and still take advantage of the six-month additional period to make the recharacterization, but you must be prepared to execute the transfer and file an amended return by October 15.
October 15: This is the final deadline to “unconvert” undesirable Year One conversions and file by the close of the “automatic” extension period.
November 16: This is the first opportunity for you to reconvert your recharacterized traditional IRA. (You could do this earlier if the recharacterization was done earlier than the October 15th deadline.)
December 15: This is the last chance for initiating additional Roth conversions for Year Two, assuming 16 days are needed to accomplish them.
This timeline does not project beyond Year Two, but barring other tax law changes, the same logic would continue to apply for future years.
1 James Lange, IRAs After TRA 97 – What Hath Congress Roth? The Tax Adviser, May 1998, at 318; James Lange and Steven T. Kohman, The Roth’s Real Advantage, Financial Planning, May 2000, at 118.
2 Code Sec. 408A(d)(6); Reg. § 1.408A-5.
3 Code Sec. 408A(d)(7).
4 Reg. §1.408A-5, Q&A-9 (a).
6 Reg. §1.408A-5, Q&A-6(c))
7 Reg. §1.408A-5, Q&A-6(a).
8 Reg. §1.408A-5, Q&A-1(a).
9 Reg. §1.408A-5, Q&A-6(b).
Reprinted with Permission from the Journal of Retirement Planning.
The advice in this article should only be undertaken with full understanding of the risks and under the direction of a qualified advisor.