Roth Recharacterization

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Topic Author
jdjd2
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Joined: Thu Feb 14, 2013 10:47 am

Roth Recharacterization

Post by jdjd2 »

In 2012, I did a tax-free rollover from an employee 401k to a traditional IRA. Earlier in 2013, I did a partial conversion of the assets from a traditional IRA to a Roth. For tax purposes, I may want to recharacterize a small part of this conversion.

I found the following discussion on bogleheads: http://www.bogleheads.org/wiki/IRA_recharacterization, with a pointer to the following: http://fairmark.com/retirement/roth-acc ... ion-rules/

In the Fairbank article it states:

"Eligible contributions

Some types of contributions are eligible for this treatment, and others are not.
...
No: tax-free rollovers. If you made a tax-free rollover to a traditional IRA, you can’t transform that event into a conversion to a Roth IRA. It doesn’t matter whether the rollover came from an employer plan or another IRA. You can’t change a tax-free rollover into a Roth IRA conversion."

Now I'm confused. I called the IRS and they said what I was doing was all okay. So what am I missing in the Fairbank reference above? It seems to suggest I could never do any Roth conversion on my 401k rollover to a traditional IRA.

I must be missing something very simple????

thanks, signed confused
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grabiner
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Re: Roth Recharacterization

Post by grabiner »

What you did was to roll over the employer plan to a Traditional IRA. Later on, you converted the Tradtiaional IRA to a Roth IRA; this is the conversion which you are recharacterizing, which is allowed.

What is not allowed is to roll over the employer plan to a Traditional IRA, and then recharacterize that rollover as a rollover to a Roth IRA (or vice versa). You can only recharacterize conversions and contributions, not rollovers.

The logic is that you may be required to undo conversions and contributions. If you contribute to a Roth IRA, and then discover at the end of the year that your income disqualifies you from contributing for the year, you need to be able to undo it; the recharacterization allows you to make it a contribution to a Traditional IRA instead. Similarly, there used to be an income limit for converting Traditional IRAs to Roth IRAs; if you made a conversion and then went over the income limit during the year, you would need to undo it. But anyone who can roll over an employer plan can roll it to either a Traditional or Roth IRA, so there was no need for the law allowing this to include a procedure for switching.
Wiki David Grabiner
Topic Author
jdjd2
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Joined: Thu Feb 14, 2013 10:47 am

Re: Roth Recharacterization

Post by jdjd2 »

Thanks for the explanation.

I found the following information for calculating earnings.

Calculating the Earnings/Loss for a Recharacterization
The IRS provides s epical formula for calculating the earnings or losses on the amount that is being recharacterized.

Here is the formula :
Net Income =
Contributions * (Adjusted Closing Balance – Adjusted Opening Balance)/Adjusted Opening Balance
Where
Net Income = The earnings or loss on the amount being recharacterized.
Contribution = The conversion or contribution amount being recharacterized.
Adjusted Opening Balance = The fair market value of the IRA at the beginning of the computation period plus the amount of any contributions or transfers (including the contribution that is being recharacterized and any other recharacterizations) made to the IRA during the computation period.
Adjusted Closing Balance = The fair market value of the IRA at the end of the computation period plus the amount of any distributions, transfers or recharacterizations made from the IRA during the computation period.

This formula is easy enough to use. For example:

Assume a Roth conversion of $29,000, a net gain to date of $1,000, and the need to recharacterize $200.
Net Income = $200 * ($30,000 - $29,000) / $29,000
= $6.89 so recharacterize $206.89

That I understand.

But, what if I convert another $10,000 on December 30, but then realize when I do my tax return that this was too much, so I not only need to recharacterize the $200, but also the $10,000 made on December 30.

Then what would be the math for this recharacterization? The $1,000 earning were on the original $29,000, but I now have $40,000 in the account. What is below does not seem correct.

Net Income = $10,200 * ($40,000 - $29,000) / $29,000
= $3,868.97 This does not seem correct.

Any thoughts on how I do this second calculation? This might be a real scenario without my going into the reasons why.

Thanks!
Alan S.
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Location: Prescott, AZ

Re: Roth Recharacterization

Post by Alan S. »

It is not correct because you did not "adjust" the opening balance.

Another point is that if you want to recharacterize more than one conversion done on different dates, two separate calculations are required because the conversions will have different opening balances.

The adjusted opening balance for the first conversion is 29,000, but for the 12/30 conversion it would be 39,000. Recharacterization the 10k conversion would then calculate out as follows: 10k* (40k -39k)/39k = 256.40. 10,256.40 would transfer back to your TIRA account.

Almost all IRA custodians have software that performs the earnings calculations for recharacterization. Nonetheless, errors can be made so it is a good idea to check this out yourself so you can compare with what the custodian comes up with. The last thing you want is to have them transfer more back to your TIRA than is correct because you will then eventually be taxed on the TIRA distributions. In addition, if your earnings were large enough, you might want to reconsider the recharacterization since those earnings would eventually be tax free in the Roth, but once you move them to the TIRA they will be taxable when you eventually take distributions. This is true even if the taxes on the current conversion are higher than you would like to pay.

Say you convert 10k and it grows to 14k. The taxes on the conversion are 2,500, but when you divide 2,500 by the current value of 14k, it means you only paid 17.8% on the value that is now in your Roth. If you recharacterize the 14k and convert it again next year, you would pay 3,500 if you were in the 25% bracket. Of course, the gains you are expecting are much less.
Topic Author
jdjd2
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Joined: Thu Feb 14, 2013 10:47 am

Re: Roth Recharacterization

Post by jdjd2 »

Thanks, this is exactly what I needed to understand. This helps me with my end-of-year strategy for the Roth conversion that is in process.
Topic Author
jdjd2
Posts: 30
Joined: Thu Feb 14, 2013 10:47 am

Re: Roth Recharacterization

Post by jdjd2 »

Also, from what I have read about recharacterization, it sounds like having separate accounts is advisable for tax purposes.

For example, assume that once I do my 2013 taxes, I then need to do a recharacterization for 2013 to stay under a tax income threshold. There are tax rules as to when I can reconvert the dollars that were recharacterized.

To keep things clean, I was considering setting up a second traditional IRA to move my recharacterization dollars back to, thus keeping clean other traditional IRA dollars that I will be converting in 2014.

Also, I will do a conversion for 2014 right after the new year, but I will not do a recharacterization for 2013 until February when I have all my tax information for 2013. So it seems to make sense to also have a second Roth account to keep the 2013 and 2014 dollars separate and not confuse the calculation of the recharacterization.

All of this seems overly complex. How do others handle this?

I am getting information from my mutual fund representative, but like to know what others think, not just what the mutual fund company suggests.

Thanks again.
Alan S.
Posts: 12629
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Roth Recharacterization

Post by Alan S. »

If you don't want the burden of opening additional TIRA and Roth accounts to assist in tracking different conversions and recharacterizations, you can still complete any transactions you could do with separate accounts. The difference in having the separate accounts is clarity for yourself, the IRA custodian and also for the IRS. In addition, the earnings calculations on conversions being recharacterized will differ if being done on different opening and closing balances of a single account vrs a combined account. This difference could either work in your favor OR against you.

For example, if you convert into a separate Roth and recharacterize the conversion, there is no calculation needed because the earnings or loss is simply the difference in value from the opening balance. You don't have to run the calculation to know how much will transfer back to the TIRA. Conversely, if you convert into a combined Roth, the recharacterization math includes the gain or loss on the entire commingled account rather than just on your converted dollars. For example, if you convert into a combined account and recharacterize the conversion, if the % gain in the total account is more than the % gain on your conversion, more dollars will transfer back to the TIRA than in the single account recharacterization. This hurts you by reducing your Roth balance more. But if your conversion gains more than the rest of the account, then less transfers to the TIRA when you recharacterize, and that works to your benefit. It can go either way. Therefore, the only sure math benefit here is clarity, not necessarily the outcome.

Another potential benefit of separate accounts is clarity for the IRS with respect to protecting you against IRS allegations of disallowed reconversions due to not meeting the time limit requirements before you can reconvert. The time limits do NOT apply if you are converting different amounts, ie assets that were not part of the earlier conversion. If you can show that the assets in the recharacterization were transferred to a separate TIRA, then a later conversion from the original TIRA cannot be a reconversion of the same assets as they are intact in the separate TIRA account. This will be illustrated on the 1099R and 5498 IRA accounts numbers as well. To put this in perspective, the IRS in INACTIVE in questioning the Roth reconversion rules, so this benefit is unlikely to be needed.

Separate Roth accounts are also helpful if you are using a strategy of multiple conversions with the intent of keeping the best performer and recharacterizing the other one.

I don't think very many people get into this type of analysis, but each person can make their own decision based on their individual situation with respect to the trade off involving separate accounts.
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