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With the recent roller coaster activity in the securities market, many individuals have seen their portfolios devalued significantly over a relatively short period. For individuals who converted amounts to Roth IRAs, this is even more disconcerting because they may now owe taxes on amounts they no longer have in their retirement accounts. So what is a taxpayer to do when he has a tax bill from a Roth IRA conversion that is now worth much less than the tax bill? There is good news; a recharacterization can make that bill disappear!

Taxation of Roth Conversions

Roth conversion amounts are treated as ordinary income for the year that the conversion occurs. This means that individuals who completed Roth IRA conversions last year were required to include any taxable amount of the conversion in the tax returns they filed for last year. For those who completed Roth IRA conversions this year, the taxable income from the conversion must be included on their tax return that they will file for this year.

Nullifying a Roth Conversion

The tax bill from a Roth conversion can be voided by recharacterizing the conversion. However, the recharacterization must meet certain specific requirements   to be considered valid. These are:

• The conversion must be completed by the individual’s tax filing deadline, including any extension. Individuals who file their tax return or file for an extension by the due date receive an automatic six-month extension for completing the recharacterization. For individuals who file on a calendar year, this six-month extension ends October 15. This means that individuals who completed Roth conversions last year have until October 15 of this year to recharacterize that conversion.

• The recharacterization must be accompanied by any net income attributable (NIA) to the conversion.

The end result is that the recharacterization amount is treated as if it was never converted for tax purposes, and therefore not included in the individual’s income.

Computing the NIA

If the Roth IRA from which the recharacterization is being done holds only the conversion that is being recharacterized (plus any earnings or minus any losses), there is no need to compute the NIA, as recharacterizing the entire balance will suffice.  The NIA is required to be computed only under the following circumstances:

• Less than 100% of the conversion is being recharacterized.

• The Roth IRA includes funding from other transactions such as a Roth IRA contribution, another Roth IRA conversion from another year or even the same year, or a transfer from another Roth IRA

While  computing the NIA is not a complex process, it  can be somewhat troublesome  , especially if the financial institution which has custody of  the Roth IRA does not provide such services. Individuals who need to calculate NIA can refer to TD 9056 for instructions, or use the formula in the Appleby NIA Calculation Worksheet Sheet at http://www.retirementdictionary.com/documents/NIAFormulaforrecharacterization.pdf :

Tip:  It is practical to keep a conversion in a separate Roth IRA until the deadline for recharacterization has passed. This negates the need to perform any NIA calculations.

Reasons for Recharacterizing a Conversion

An individual can recharacterize a Roth IRA conversion for reasons which include the following:

• The individual simply wants to. An individual need not have a reason, other than simply feeling like he no longer wants to have a conversion done for that year, in order to recharacterize the conversion.

• The individual is unable to pay the taxes that will be owed on the conversion

• The conversion will put the individual into a higher tax bracket, resulting in other income- as well as the Roth conversion amount- being taxed at a higher rate

• The conversion will result in the individual being subject to alternative minimum tax

• The conversion will result trigger a  surcharge for his Medicare Part B coverage

• The conversion was invalid or was a failed-conversion. This can occur if a conversion was recharacterized and the amount reconverted too soon

• The conversion amount has lost market value, and the individual does not want to pay a tax bill for a conversion value that he no longer has

• The individual is ineligible for the conversion because his modified adjusted gross income (MAGI) is more than $100,000 and/or his tax filing status is married-filing separately ( Note: These restrictions  will be repealed effective 2010.

It’s Not All or Nothing…

A recharacterization need not be for the entire conversion amount. Instead, an individual can choose to recharacterize a partial amount of the conversion. When doing a partial recharacterization, the conversion amount used in computing the NIA is determined as of the date the conversion occurred. For instance, if the individual converted $100,000, and wants to recharacterize $80,000, the NIA should be computed on $80,000 even if the market value of the conversion has fallen below $80,000.

Example: John converted $100,000 from his traditional IRA to his Roth IRA in January of  this year. The securities in which the $100,000  was invested is now worth $60,000. John wants to keep some of the assets in his Roth IRA. He had determined that reducing his taxable income by $80,000 will keep him within the lowest possible threshold. John decides to recharacterize $80,000 of the $100,000. Even though the $100,000 is now worth $60,000, John must compute the NIA on $80,000. Once the NIA is determined, it must be added to the $80,000. A recharacterization of $80,000 plus the NIA (which can be earnings or losses, as explained earlier) will have  the net effect of a recharacterization of only $20,000.

Individuals who recharacterize partial conversion amounts may need to file IRS Form 8606.

Partial Recharacterization: Picking Assets to Recharacterize ….

If an entire conversion is being recharacterized, and  no activity occurred in the Roth IRA, other than the conversion and any interested/dividend activity,   recharacterizing the entire balance will suffice. However, if only a partial amount of the conversion is being recharacterized,   or other activity occurred in the Roth IRA, the IRA owner will need to choose which assets are included in the recharacterization. If the Roth IRA has only cash and/or money market funds, it’s as easy as recharacterizing a dollar amount.   However  if other assets, such as stocks and mutual funds are involved, the individual will need to make sure that the market value of the shares amounts that are recharacterized is equivalent to the ‘Conversion amount that is being recharacterized + NIA’.

It is up to the individual to choose which assets will be included in the recharacterization. If the value of the recharacterization is $100,000, then any combination of assets can be recharacterized, as long as the total market value is $100,000. Individuals who are requesting partial recharacterizations should impress upon the financial institution the importance of completing the transaction on the day received, or ‘as of ‘the day received if possible. If the financial institution computes the NIA, this may not be an issue as they are responsible for ensuring that the NIA is accurate. However  if the IRA owner is responsible for computing the NIA, a delay in processing can result in a change in the NIA if the value of the assets being recharacterized changes.

Reconverting the Recharacterized-Conversion

The IRA owner can reconvert the amount or a percentage of it at a later date after the recharacterization. However, caution must be exercised here as there are time limitations on when this can be done.  Under these time limitations, a reconversion cannot occur before the later of:

• The beginning of the taxable year following the taxable year in which the amount was converted to a Roth IRA ,or

• The end of the 30-day period beginning on the day on which the recharacterization occurs

Let’s look at examples:

Example 1:

Jane converted her traditional IRA to  a Roth IRA on October 1 of last year.

She recharacterized the conversion on August 15 of this year.

Jane can reconvert the amount no earlier than September 15 of this year, because September 15 is at least 30-days after the recharacterization, and it is later than January 1 of this year (January 1 of this year is the beginning of the year following the taxable year of the conversion.

Example 2:

Mary converted her traditional IRA to  a Roth IRA on January 1 of this year.

She recharacterized the conversion on August 15 of this year.

Mary can reconvert the amount no earlier than January 1 of next year, because January 1 of next year is the beginning of the year following the taxable year of the conversion, and is later than 30-days after the recharacterization.

Amounts that are reconverted must include applicable NIA, so as to accurately determine the amount that is subject to this reconversion limitation. For instance, if 40% of a traditional IRA was converted and subsequently recharacterized, the market value of the recharacterization must be adjusted for NIA at the time of reconversion in order to ensure that the reconversion limitation is applied to the correct amount.

Conclusion

Individuals who converted amounts to Roth IRAs should check the Roth IRA to determine if the amount has lost market value and determine whether they want to recharacterize the amount. The financial institution should be contacted in advance of the recharacterization deadline in order to determine if they will calculate the NIA, and if not, the calculation should be done and the NIA included in the amount that the financial institution is instructed to recharacterize.  It is of paramount   importance that the request should be submitted to the financial institution before the recharacterization deadline, so as to prevent the IRA owner from being stuck with a tax-bill for something from which no financial benefit was received.