by Barry C. Picker, CPA/PFS, CFP
© 1999, Barry C. Picker
The following copyrighted article is available exclusively on the Roth IRA Web Site:
As taxpayers are now gathering their 1998 tax data, many are finding that their income is too high to have made a conversion or a contribution to their Roth IRAs. Others are finding that their tax liability as a result of their conversion is higher than they thought it would be. Still others made an annual contribution to their traditional IRA, and now wish they had made the contribution to a Roth IRA. The answer to each of these conditions is a recharacterization, either complete or partial.
A recharacterization the movement of assets from one flavor of IRA to another (Roth to traditional or vice versa) and is considered under the tax law as if the assets had originally gone into that second, or "target" IRA. In the case of a Roth conversion, a recharacterization is an "undo." It is accomplished via a trustee to trustee transfer of all or part of the account or a retitling of the account within the same custodian. You CANNOT take a withdrawal and redeposit it back in the "target" IRA. You have until the due date of the tax return, including extensions, to do a recharacterization. While a complete recharacterization is fairly straightforward, partial recharacterizations can get complicated. A recharacterization must include the income attributable to the amount being recharacterized. In a complete recharacterization, this is not an issue. You just move the entire account balance to the "target" IRA. In a partial recharacterization you will have to calculate the attributable income. This becomes a more detailed computation than just doing a full recharacterization.
Let’s look at some reasons why you may need or want to do a recharacterization.
Your conversion is invalid
There are two ways your conversion can turn out to be invalid. One is that your Modified Adjusted Gross Income (MAGI) exceeds $100K. The second is that your spouse refuses to file a joint return (or you decide to file separately, for some reason). In any event, the only solution is a complete recharacterization of the entire Roth account back into a traditional IRA. If the Roth consists only of the converted assets, including any assets acquired in the Roth using converted funds, then a compete recharacterization is accomplished by merely retitling the account as a traditional IRA, or transferring, trustee-to-trustee, the assets back into a traditional IRA account. However, if you had also made an annual Roth contribution to the same Roth account, and you wish (and are able) to leave that contribution in the Roth, then you will have to make a partial recharacterization. To accomplish this you need to compute the ratio (I hate this technical computational stuff) of the value of the conversion to the sum of the conversion plus the annual contribution, and multiply this ratio by the current Roth value. For example (the only real way to understand this), if your conversion was valued at $48K and you made a $2K annual contribution to the same Roth account, then 96% of the value of the Roth is attributable to the conversion. If at the time of the recharacterization, the Roth is worth $75K, then 96% or $72K worth of Roth assets, must be recharacterized back to the traditional IRA. You need not choose 96% of each asset; any way you come up to $72K is fine.
If you converted to the Roth and now wish to undo it, perhaps because the Roth value has declined, you would follow the above rules. Keep in mind however that if you plan on reconverting to the Roth, you will be doing so in 1999 and will not have the four year spread of income attributable to the conversion. You will have also lost a year in both the five year period for tax free withdrawals (the account must be over five years old to take tax free withdrawals of account earnings), as well as the five year period for the penalty on withdrawing converted funds (converted funds withdrawn within five years are subject to the 10% early withdrawal penalty, unless an exception applies).
Your 1998 IRA contribution went to the wrong type of IRA
Perhaps you contributed to a Roth IRA, and your income exceeds the MAGI limits for annual Roth contributions. Or perhaps you contributed to a traditional IRA, and now you realize that it’s not deductible making the Roth the better choice for you. Even if the traditional IRA contribution is deductible, you are now convinced the Roth is a better deal. Once again, recharacterization saves the day. You have the right to recharacterize your annual contribution in either direction, from Roth to traditional, or from traditional to Roth. The same deadline rules apply as to conversion recharacterizations, that is, you have until the due date, including extensions, to recharacterize an annual contribution. If you are recharacterizing a Roth contribution into a traditional IRA completely, then there is no computational issue since that would by definition have to be a complete recharacterization of the account. If your income is in the Roth contribution phase out range (married filing joint with MAGI between $150K and $160K; married filing separately with MAGI between $0 and $10K; other unmarried taxpayers with MAGI between $95K and $110K), you only need to recharacterize the excess over the permitted Roth contribution. You compute the ratio of the excess to the total contribution, and multiply that by the value at the time of the recharacterization, to get the amount that needs to be recharacterized. For example, if your Roth contribution limit is $800, and you contributed $2K, then you would need to recharacterize 40% of the current value of your Roth, into a traditional IRA.
If you want to recharacterize a traditional IRA contribution into a Roth IRA, you use the ratio of the contribution to the sum of the contribution plus the beginning of the year IRA value. So if your traditional IRA was worth $23K on January 1, 1998, and you contributed another $2K to the account, you can recharacterize the contribution by moving 8% of the current IRA value into the Roth. If the account is now worth $30K, you would recharacterize 8% or $2,400, into the Roth IRA.
You didn’t realize the tax cost of conversion
You’re preparing your 1998 income tax return, and your tax liability is higher than you ever envisioned. You just didn’t quite grasp how the conversion would affect your tax liability. Worse, you just don’t have the ready cash to pay it. Can you recharacterize? Sure, there’s no requirement that you be ineligible for a Roth in order to recharacterize. The rules have made it so you can recharacterize for any reason. SHOULD you recharacterize? That’s another matter altogether. You can, of course, revisit the reasons why you wanted to convert to the Roth in the first place, and see if they are still valid. Assuming they are, see if you can somehow come up with the tax dollars to pay for the conversion. If this proves to be impossible, and you must recharacterize to avoid having to dip into the Roth itself to pay the taxes, see if a PARTIAL recharacterization, rather than a complete recharacterization, is the answer.
Let’s look at an example to see how this would be accomplished. Ken converted his IRA to a Roth when it was worth $200K. Ken now realizes that he will have to pay more tax than he wants to. Ken’s IRA is currently worth $220K, and Ken wants to do a partial recharacterization so that only $80K of conversion income remains. Since Ken wants to eliminate 60% ($120K is 60% of $200K) of the conversion, he will have to recharacterize 60% of the current Roth IRA value. Since 60% of $220K if $132K, Ken will have to find $132K worth of assets in the Roth to recharacterize back to his traditional IRA.
One thing you CANNOT do in a partial recharacterization is to "cherry pick" the stocks that want to recharacterize in order to take advantage of decline in value of those stocks. It won’t work. You can, of course, pick and choose which stocks to move in a partial recharacterization. But the computation of income is based upon the account as a whole.
For example, Ellen converted her 3 stock IRA into a Roth. Stock X was worth $15K, stock Y was worth $20K, and stock Z was worth $55K, for a total conversion of $90K. The value of stock Z went down $20K to $35K. The value of the other 2 stocks remained exactly the same. Ellen wants to recharacterize stock Z, thinking that this will reduce her total conversion value to $70K, a decrease of $20K. But it will not. If Ellen recharacterizes only stock Z, she will have recharacterized 50% of the current value of $70K. Since the total loss on the account is $20K, 50% of this amount, or $10K, is attributable to the stock Z that is being recharacterized. Therefore, the original conversion will decrease by $45K ($35K current value of Z plus the $10K of loss attributable to Z) due to the recharacterization, leaving $45K as the taxable conversion even though the value of the stocks remaining in the Roth is only $35K (stock X being worth $15K and stock Y being worth $20K).
To illustrate using another example, Rosie converted her 2 stock IRA to a Roth. Her first stock, AnythingDotCom was worth $10K. Her other stock, RipOff Swamplands was worth $50K. Therefore, her total conversion is $60K. Rosie is thrilled as she watches AnythingDotCom rise in value, and is now worth $120K. She was so thrilled, that she failed to notice as RipOff slowly sunk in value, and is now worth only $5K. Rosie now wants to recharacterize RipOff, in the hope that she can use the $45K decrease in value to reduce the tax to be reported on the conversion. However since the total Roth value has increased, Rosie would accomplish nothing by recharacterizing that one stock. In fact, if Rosie did the recharacterization of RipOff, she would harm herself by effectively reducing her conversion by $2.4K, while restoring an asset worth $5K to her traditional IRA. However, based on the wording in the Proposed Roth IRA Regulations, if Rosie has converted each stock separately, into separate Roth IRA accounts, she could have recharacterized the entire account holding RipOff, and reduced her conversion by RipOff’s $45K loss in value.
You’re on your own
If you’re doing a complete recharacterization, you should not have any problem. But if you’re doing a partial, you cannot count on your IRA custodian to come up with the right numbers. Your choice then is to either do the computation yourself, or get someone to do it for you. Recharacterizations are irrevocable, so if a mistake is made and you recharacterize too much, you’re stuck. On the other hand, if you recharacterize too little, you may be subject to a penalty, if the recharacterization was required. It’s imperative that you stay on top of the situation. It’s your money.
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.