2010 may be remembered as the year of Roth conversions. Remember that after-tax dollars are invested in a Roth IRA while pre-tax dollars go into a traditional IRA. The advantage of a Roth IRA is the withdrawals from the account are tax free. The Internal Revenue Code (IRC) permits Roth conversions, the transfer for funds from a traditional IRA to a Roth IRA. However, it also requires that taxes be paid on the funds converted. Usually the converted funds are taxed in the year of the conversion. For example if you did a Roth conversion in 2009 then the funds transferred from the traditional IRA to the Roth IRA would have been taxed on your 2009 tax return.
Things were different in 2010. The IRC, for 2010 only, allowed the taxes on the converted funds to be taxed over two years (2011 and 2012). While this didn't reduce the total tax bite, it did spread the taxes out over two years making the taxes a little easier to pay.
Many taxpayers experienced “sticker shock” when they saw their 2010 tax returns on April 18th this year and have started to have second thoughts about the conversion.
All is not lost. If you are in that boat then you have until October 17, 2011 to recharacterize (undo) your Roth conversion. Before you make that decision there are a couple of important considerations.
First, the two year tax deal is lost forever if the Roth conversion in recharacterized. The two-year payment option was only available for 2010 conversions. We’re not in Kansas anymore (unless you happen to live there) and 2010 ended about six months ago.
Second, only the funds that with converted from a traditional IRA to a Roth IRA can be recharacterized. That seems obvious, no? But some people held out funds during the conversion to pay the taxes on the conversion. Assume that a client withdrew $200,000 from a traditional IRA and converted $170,000 into a Roth IRA, withholding $30,000 for the tax bill on the conversion. In a recharacterization only $170,000 can be converted back into the traditional IRA, taxes will have to be paid on the $30,000 that didn’t find it’s way into the Roth IRA.
Third, gains or losses on funds in the Roth IRA must be considered in any recharacterization. Let’s look at gains first. Assume $200,000 were converted into a Roth IRA and now the taxpayer only has sufficient funds to pay taxes on 70% of the conversion. That means that 30%, or $60,000, of the original conversion needs to be recharacterized. Assume also that the converted funds, due to some good investment decisions, now have a $300,000 balance. The Roth fund has earned $100,000 of tax-free investment income. However, the writers of the tax code took this into account. Sorry. If 30% of the converted funds are transferred back to a traditional IRA then 30% of the gain on the Roth IRA must also be converted back as well. That means that rather than recharacterizing $60,000 the taxpayer will have to recharacterize $90,000 ($60,000 from the original Roth conversion plus $30,000 from the investment gain).
Now, what if the Roth IRA had a loss? Assume the same set of facts as above, except that the Roth IRA had losses and the account balance has declined to $140,000. Unless funds are recharacterized the taxpayer will still have to pay taxes on the full conversion amount of $200,000. To recharacterize 30 percent as above the taxpayer will recharacterize $60,000 (30% of $200,000) but only transfer $42,000 (30% of $140,000) back to the traditional IRA. If the taxpayer recharacterized and transferred back $42,000 then taxes would be due on $158,000 ($200,000 - $42,000).
Don’t you just love taxes!
Email me with tax or investment questions and I'll consider them for future blogs.
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