Roth IRA Recharacterizations:
The Chance for a "Do-Over"

By Ann Siford, Professional Network Manager, Equity Trust Company
9/14/09

Many financial practitioners are preparing for an avalanche of Roth IRA conversion requests from their clients when the modified adjusted gross income (MAGI) limits for conversions to Roth IRAs are lifted on January 1, 2010.

While this is a tremendous opportunity for many high-income individuals to enjoy the benefits of Roth IRAs, converting is not without risk.

This risk stems from the fact that income taxes must be paid on the value of the IRA at the time of the conversion. If the account’s value then falls substantially soon after the conversion is made, an individual will have paid a relatively large amount of taxes on what is now a much smaller account — perhaps even smaller than the amount of taxes paid.

A Roth Conversion “Insurance Policy”

Fortunately, individuals have the opportunity for a “do-over” in the event that their accounts decline in value significantly after a Roth IRA conversion. It’s called an IRA recharacterization—or as Michael J. Jones, a partner with Monterey, California's Thompson Jones LLP, puts it, an “insurance policy” against this very real risk.

Here’s how it works:

Suppose your client converts a $1 million Traditional IRA to a Roth IRA in January 2010. At that time, the client is potentially looking at federal and state income taxes totaling $400,000. But over the next year, the markets take another tumble and by early 2011, the Roth IRA is only worth $800,000.

Now, the client is paying $400,000 in taxes on what is no longer a $1 million account, but an $800,000 one. If the client decides that this tax bite is too much, he or she has until his or her tax filing deadline plus extensions to recharacterize the Roth IRA—or in other words, switch it back to a traditional IRA and get any tax payments back.

[Note: taxes owed on Roth conversions made in 2010 may be carried into 2011 and 2012.]

For a conversion made in January 2010, the client would have until October 15, 2011 to complete the recharacterization.

“A lot can happen in the market during this time,” says Jones. “So I’m advising my clients who want to do conversions to commit right away to extending their filing date to give them the longest possible window to exercise this option and get their income taxes back.”

Recharacterization is accomplished by moving assets from the IRA that first received the contribution or conversion to the IRA where the client wants the assets to be maintained. Clients can recharacterize IRAs once each year.

Pay Taxes from Non-IRA Funds

The potential opportunity for a recharacterization is another reason why clients should pay income taxes due at the time of conversion out of non-IRA funds. In our example above, if the client used traditional IRA funds to pay the income taxes, the potential recharacterization amount would be $400,000 less than the amount of the taxable distribution that occurred.

“In other words, the client will pay income taxes on $400,000 in spite of making a recharacterization,” Jones explains. “But if he or she pays the income taxes on the conversion out of non-IRA funds, the entire amount of the taxable distribution that occurred due to the Roth conversion can be eliminated in a recharacterization.

“Practitioners should make sure their clients understand that paying income taxes out of the retirement account being converted means that a complete recharacterization will be beyond reach.”

Can You Recharacterize the Losers?

At this point, you might be wondering if a Roth IRA can be partially recharacterized. In other words, if a portion of the account has gone down in value but the rest of the account has remained stable or appreciated, can clients recharacterize the losers and keep the winners?

There is a strategy advisors are having clients implement to give them the flexibility to accomplish just this: setting up more than one Roth IRA at the time of the conversion, perhaps according to asset classes and/or level of risk. For example, a client’s asset allocation may include bonds, equities and cash instruments.

“By establishing three different Roth IRAs, one for each of the three asset classes, clients can recharacterize just the Roth IRA (or IRAs) holding the asset class (or classes) that have fallen in value,” says Jones. “But they need to think about and decide on this strategy when they first convert from a traditional to a Roth IRA.”

Ann Siford is Manager of the Professional Network at Equity Trust Company, a custodian specializing in the investment of retirement funds in alternative assets. The Professional Network provides professionals in the self-directed retirement account industry with educational resources, access to expertise from peers and industry experts and targeted promotional tools to aid in expanding their business.

For more information on the Professional Network, contact Ann at 1-888-382-4727 x255 or visit http://www.trustetc.com/pronetwork to sign up.

Disclaimer: Equity Trust is a passive custodian and does not provide tax, legal, or investment advice. It does not endorse or recommend any contributor, company, or specific investments. Any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Whenever making an investment decision, please consult with your legal, tax, and accounting professionals.