How does IRA recharacterization work if you switch funds while converting?

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JustinR
Posts: 417
Joined: Tue Apr 27, 2010 11:43 pm

How does IRA recharacterization work if you switch funds while converting?

Post by JustinR » Sun Aug 27, 2017 11:36 pm

From what I understand, if during the conversion you're just buying the same fund, it's super simple since it's just like transferring the same shares from one account to another. If you recharacterize, I assume the fund just gets transferred back into the first account as is?


But what if during the conversion you sell Fund A in your tIRA to buy Fund B in your rIRA, and then recharacterize?

- Is Fund B transferred back to the tIRA? Does Fund B get sold to buy Fund A back in the tIRA?

- What if your tIRA is at a different provider who doesn't carry Fund B? Does Fund B get sold and then it gets transferred as cash back to the tIRA?

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celia
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Re: How does IRA recharacterization work if you switch funds while converting?

Post by celia » Mon Aug 28, 2017 1:00 am

JustinR wrote:
Sun Aug 27, 2017 11:36 pm
From what I understand, if during the conversion you're just buying the same fund, it's super simple since it's just like transferring the same shares from one account to another. If you recharacterize, I assume the fund just gets transferred back into the first account as is?
I think there are several things you need to know about recharacterization before you even convert. For example, see our wiki pages:
https://www.bogleheads.org/wiki/Roth_IRA_conversion and
https://www.bogleheads.org/wiki/IRA_recharacterization .

The short answer is that you will be asked what Roth account you want to recharacterize from and what TIRA account you want the money to go to. Then you will be asked what fund in the Roth would you like the money taken from and what fund in the TIRA do you want to put the money into. You will be asked how much of the original conversion you want to recharacterize, basically "all" or what percentage or dollar amount of the original conversion to go back. Note that not only does the original conversion amount that you request go back, but it is adjusted for gains or losses in the Roth since the conversion was made. The custodian will do the official calculation, but you can do your own rough calculation to estimate what will happen.

Now here is where many people get a big surprise: They converted $10K into a new Fund F in an existing Roth that had $90K in it already. On conversion day, the Roth now has $100K in it and 10% of that is from the conversions. If you later recharacterize the entire conversion, 10% of the Roth will have to leave the account. (Let's now say, this is our baseline scenario.)

Scenario 1: The new Fund F doubled and is now worth $20K while the rest of the Roth stayed the same value. The Roth is now worth $110K and you need to withdraw $11K. You can choose to remove shares from Fund F or any other fund in the Roth. And you can put the money in any fund you want in your TIRA.

Scenario 2: The new Fund F stayed the same price, but the rest of the Roth grew by $50K. The Roth is now worth $150K and you would need to remove $15K. Hey, the converted money in Fund F is still worth only $10K and I have to remove $15K? Yes, if you want to recharacterize the entire amount. But, if you ask them to only remove $10K from Fund F, what will happen? That would be removing only 10/15 of the amount or 66.66% of what you are supposed to remove if you are recharacterizing the entire conversion. The remaining 33.34% will be considered a conversion that you are keeping. 33.34% of the $10K conversion is $3,334 for which you will have to pay conversion taxes for the year of conversion.

So how do you keep this from happening? Always convert into a new (empty) Roth. Always convert each fund into a separate new (empty) Roth. Then you can control exactly what you want to recharacterize since 100% of the new Roth account is a conversion.

Be sure to check the wiki links for more examples.
A dollar in Roth is worth more than a dollar in a taxable account. A dollar in taxable is worth more than a dollar in a tax-deferred account.

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