by Barry C. Picker, CPA/PFS, CFP
© 1998, Barry C. Picker
The following copyrighted article is available exclusively on the Roth IRA Web Site:
The Internal Revenue Service has issued Notice 98-50, which modifies the proposed regulations to Sec 408A by having now placed a limit on how many times an individual can reconvert a traditional IRA into a Roth, once an account has already been recharacterized. The limit is effective as of November 1, 1998, and covers the period November 1, 1998 through December 31, 1999 (at which time the IRS computers may blow up altogether!).
Basically, the IRS has now said that a taxpayer only gets one bite at the "recharacterize/reconvert" apple.
Once a taxpayer has converted their IRA to a Roth IRA, and the value has declined subsequent to that conversion, the taxpayer can recharacterize that conversion, and reconvert (the second conversion) the IRA into a Roth. The taxpayer will then pay tax based upon the IRA value at the time of the latter conversion. If the value of the account then continues to decline, the only option available to the taxpayer is to do a recharacterization back to a traditional IRA. But the taxpayer will not be able to reconvert that amount during the same year. Should the taxpayer do a third conversion, the third conversion will be valid in terms of the fact that the retirement money will now be in a Roth IRA, but for income tax purposes, the taxpayer will be taxed on the value at the time of the second conversion. Any reconversions prior to November 1, 1998 are not counted, so that even if the taxpayer has already done ten recharacterization/reconversions prior to November 1, 1998, the taxpayer is still entitled to one reconversion between November 1, 1998 and December 31, 1998, AND one reconversion between January 1, 1999 and December 31, 1999.
To illustrate, assume a taxpayer converted her IRA to a Roth on May 15, 1998. On September 8, 1998 she recharacterized that IRA back to a traditional IRA. On September 28, 1998 she reconverted into a Roth, and on October 15, 1998 recharacterized once again into her traditional IRA (thereby driving her broker out of his mind, which is why my guess is that the brokers and fund companies are the ones who pressured the IRS to put this limit on, but I digress). She can now do ONE conversion between 11/1/98 and 12/31/98, and if she does that conversion AND recharacterizes that conversion prior to the due date of her 1998 tax return, with extensions, she will then be permitted to do ONE reconversion in the 1999 calendar year. Any "excess reconversions" (the new term created in this IRS Notice) will be ignored.
Any conversion and reconversion that fails due to the fact that the taxpayers AGI exceeds $100K, or otherwise fails to qualify for a conversion, are ignored for purposes of limiting the 1999 conversions.
For example, John converts his IRA to a Roth November 15, 1998. On January 5, 1999, John recharacterizes his IRA back to a traditional IRA. John will be able to do ONE conversion into a Roth in 1999. However, if John recharacterizes his IRA on January 5, 1999 because he determines that his 1998 AGI will exceed $100K, then John's 1998 conversion and subsequent recharacterization is ignored. In that case John can do a conversion in 1999, and still do a 1999 recharacterization/reconversion. This can lead to some interesting tax planning.
Take the following scenario. Tom and his wife have a joint income well within the $100K AGI limit for conversions. Tom converts his traditional IRA to a Roth in December, 1998, when the value of the IRA is $120K. By February, 1999 the account value has dropped to $95K and Tom decides to forego the four year income spread, and recharacterize and then do another conversion at this value. By October 1, 1999, Tom's 1998 income tax return is still on extension, and the value in the IRA account is now down to $60K. Under the new rules, Tom cannot do another recharacterization/reconversion at this time, UNLESS his 1998 conversion fails under the law. Therefore if Tom decides to file a separate return, thus causing his 1998 conversion to fail, Tom will be permitted to do another (but only one more) 1999 recharacterization/reconversion, thus saving the income tax on the difference between the $95K and $60K value.
Because the Notice is effective for only the period from November 1, 1998 through December, 31, 1999, this issue will have to be revisited at least one more time. The Notice indicates the possible approaches to reconversions in the final regulations might be to prohibit reconversions altogether within the same year, or may put a minimum time span between a recharacterization and a reconversion.
In my opinion, the net result of this Notice will be to reduce the number of taxpayers
who will do conversions. After the market gyrations we've seen this year, taxpayers will
be afraid to convert for fear that the market value will decline, and taxpayers will find
themselves in a position of either paying tax on value no longer there, or of canceling
their Roth conversion altogether. Looking at this strictly from the IRS point of view, I
don't see where the taxpayer's ability to do recharacterizations and reconversions is
harming the revenue. In my conversations with the IRS regulations writers, no one there
seemed upset at the multiple reconversion scenario. The ones who seemed the most upset
were the banks, brokers and mutual fund companies. So guess who I think is behind this
Notice?
The Author:
Barry C. Picker is a Certified Public Accountant with the Personal Financial Specialist
designation, and is a Certified Financial Planner licensee. He runs his own accounting and
financial planning firm located in Brooklyn, NY, and is also a member of the NYS Society
of CPAs Estate Planning Committee. He has taught seminars and written articles on tax
topics, and has been quoted in various publications. In addition, he is part of a panel
that answers tax questions on America Online at keyword:TaxLogic. He can be reached at
(718) 934-4300, or via E-Mail at BPickerCPA@cs.com.