Re-characterization of Roth contribution "opportunity" issue

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mystified
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Re-characterization of Roth contribution "opportunity" issue

Postby mystified » Fri May 19, 2017 12:24 pm

My Roth IRA has several different funds in it including a money market fund. Last year I converted 100K from the money market account in my tIRA to the money market account in my Roth IRA. Of course, this was a taxable event and after looking at the tax consequences while filling out my tax return I realized it had been a foolish move. I thought a recharacterization of the entire 100K was the easy answer and probably is still is the way to go.

However, when I began the process, I was told by the company that holds my Roth IRA that I would need to transfer 112K out of the Roth for a complete recharacterization. The explanation being that although the 100K had only earned $600 sitting in the money market account, the amount the entire Roth had earned while this 100K sat in the money market account had to be considered in the recharacterization, something the representative called "opportunity' and and said came from their IRS guidelines for this type of thing. I had viewed my 100K as sitting all by itself in the money market fund and its earnings as being separate, but that seems not to be the case, even though I never moved any money from the money market anywhere during the entire time the 100K sat in it.

As you can imagine, I am a bit taken back at having to take 12K extra out of my Roth that I didn't earn, put it into my tIRA and then pay taxes on it again when I get distributions out of my tIRA. For my specific situation it amounts to being taxed twice on this 12K. However, the tax ramifications of leaving the conversion stand appear to be much worse, so I will have to re-characterize.

Is there a way out of this that has a happy ending?

Chip
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby Chip » Fri May 19, 2017 2:05 pm

mystified wrote:Is there a way out of this that has a happy ending?


Hi, and welcome.

I'm afraid there's no way around what the company rep told you. IRS rules are quite clear. These rules are why almost everyone here recommends that each conversion be placed in an empty Roth account.

But you don't have to recharacterize all of conversion. You can do a partial recharacterization, which will reduce the amount of gain that has to go back into your tIRA. For example, if you recharacterized 50k of the original 100k only 56k would have to go back into the tIRA. You would owe taxes on the remaining 50k conversion.

You can find a good discussion of recharacterization in the wiki.

FactualFran
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby FactualFran » Fri May 19, 2017 2:47 pm

mystified wrote:As you can imagine, I am a bit taken back at having to take 12K extra out of my Roth that I didn't earn, put it into my tIRA and then pay taxes on it again when I get distributions out of my tIRA. For my specific situation it amounts to being taxed twice on this 12K. However, the tax ramifications of leaving the conversion stand appear to be much worse, so I will have to re-characterize.

Please explain how the 12K is being taxed twice. It is an investment gain while money was in a Roth IRA; it was not taxed while in the Roth IRA. It is part of a recharacterization; it was not taxed as part of the recharacterization. As a result of the recharacterization, it is now part of a traditional IRA and will be taxed, once, when distributed from the traditional IRA.

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House Blend
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby House Blend » Fri May 19, 2017 3:27 pm

+1 to what Chip said.

I'm going to guess that maybe you are normally in the 25% bracket. (Much higher, and you would be using a backdoor Roth and wouldn't have large amounts in a trad IRA in the first place.)

In that case Roth conversions that keep you in the 28% bracket or lower probably aren't a huge mistake even if they are sub-optimal. It does require that you have the substantial cash available to pay the income tax, and assumes that no other "interesting" tax effects are in play (e.g., from state taxes, or Pease phaseouts, or other tax credit phaseouts).

Use tax software to see how it really works out, but here's an illustration for a simple case with no complicating factors:

If you recharacterize $99K, then your taxable income goes back to a saner level, only up by $1,000, and your Roth gets to keep $1,120. So you are paying a (Federal) tax cost of $250 on a Roth "contribution" of $1,120. In effect you are Roth converting at a 22.3% tax rate.

If your marginal rate on tax-deferred withdrawals in retirement turns out to be less, then you're worse off, but it's notoriously hard to predict these things if retirement is far into the future. As I said, even in the worst case it's probably not a huge mistake.

Now suppose you reduce the recharacterized amounts by additional increments of $1K. If/when you reach the 28% bracket, then you are paying $280 Federal to put $1,120 in the Roth; that's exactly the same as a 25% tax rate. So here you are placing a slightly riskier wager -- that 25% would be a decent tax rate for your tax-deferred withdrawals in retirement.

mystified
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby mystified » Fri May 19, 2017 4:06 pm

@ FactualFan

What I mean is that I paid tax on the contributions to the Roth IRA and since this 12K is not part of my gains on the 100K I am essentially having to remove the money from the Roth IRA and pay taxes again on it when I distribute it from the tIRA (or pay taxes on it when move it back to the Roth at some future date if that becomes appropriate.) Now you could argue that I am paying taxes on the gains I made while the money was in the Roth and that it is only being taxed once, of course. So if you take that view, I would say that I am being taxed on gains I had expected I had no tax due on because they were in the Roth. Respectfully, I say the outcome is virtually the same whichever way we word it. I will, in the future, owe taxes I hadn't expected to owe on money I thought I had already paid the full amount of tax due on, even if that amount was zero, which I think is the same thing you are saying.

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Fri May 19, 2017 8:32 pm

Take a look at the linked article that explains what has happened. (Especially examples 2A & 2B) This is a terrible "gotcha" that I wish investment company representatives knew enough to warn about. Thanks to several bogleheads, I was forewarned.

Edited link. If it doesn't work please google the title, Splitting A Roth Conversion Into Multiple Accounts To Isolate Investments For Strategic Recharacterization

https://www.kitces.com/blog/splitting-a ... erization/

Regards,

hushpuppy
Last edited by hushpuppy on Fri May 19, 2017 10:18 pm, edited 1 time in total.

mystified
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby mystified » Fri May 19, 2017 10:01 pm

@ hushpuppy

Couldn't follow your link. I think the abbreviation thwarted it.

hushpuppy
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Fri May 19, 2017 10:22 pm

mystified, I edited link see previous post. Sorry about that. :oops:

Regards,

hushpuppy

hushpuppy
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Fri May 19, 2017 11:44 pm

Mystified, because you have not yet re-characterized, I am wondering if you could transfer the Roth assets you do not want to re-characterize to a different custodian and then re-characterize just the portion of the money market fund that you desire. (Effectively isolating Roth assets, before re-characterization) Or, so as not to disturb your previous Roth positions, transfer the Roth money market fund to another custodian and re-characterize the Roth money market fund after the transfer is complete. I realize this would not be ideal and I would consult with more knowledgeable bogleheads before proceeding.

Regards,

hushpuppy

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celia
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby celia » Sat May 20, 2017 2:20 am

mystified wrote:However, when I began the process, I was told by the company that holds my Roth IRA that I would need to transfer 112K out of the Roth for a complete recharacterization. The explanation being that although the 100K had only earned $600 sitting in the money market account, the amount the entire Roth had earned while this 100K sat in the money market account had to be considered in the recharacterization...

This underlined is correct. You have to look at the entire Roth account as the IRS considers all the money in it to be co-mingled.

I had viewed my 100K as sitting all by itself in the money market fund and its earnings as being separate, but that seems not to be the case, even though I never moved any money from the money market anywhere during the entire time the 100K sat in it.

You are apparently looking at only an individual fund, not the ENTIRE account.

As you can imagine, I am a bit taken back at having to take 12K extra out of my Roth that I didn't earn, put it into my tIRA and then pay taxes on it again when I get distributions out of my tIRA. For my specific situation it amounts to being taxed twice on this 12K. However, the tax ramifications of leaving the conversion stand appear to be much worse, so I will have to re-characterize.

You appear to be surprised because you didn't understand Roth conversions and recharacterizations. Let's look at some simple examples so you can understand.

On the day you convert, look at that percentage the converted amount is compared to the whole account. Let's call it x%. When you recharacterize that conversion, the custodian has to remove x% of the account value on the day of recharacterization.

Sounds simple. So let's look at some examples.
Example 1. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund MM into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has grown to $120K, fund B has grown to $110K, and fund MM is still worth $100K making an account value of $330K and you have to remove 33.33% of it or $110K. Which fund(s) would you decide to recharacterize? (By the way, you don't have to recharacterize from the same fund you added to in the conversion.) The "extra" $10K you have to recharacterize is NOT from a contribution. It is 33.33% of the $30K that the account grew.

Example 2. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund MM into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has decreased to $80K, fund B has decreased to $90K, and fund MM is still worth $100K making an account value of $270K and you have to remove 33.33 of it or $90K. Which fund(s) would you decide to recharacterize? The "lost" $10K you don't have to recharacterize is NOT from a contribution. It is 33.33% of the $30K that the account lost.

Example 3. On the day you convert, your Roth contains $100K of fund A and $100K of fund B and you convert $100K of fund MM into the same account. The conversion is 33.33% of the account's value on the day of conversion. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize, but fund A has grown to $115K, fund B has decreased to $85K, and fund MM is still worth $100K making an account value of $300K and you have to remove 33.33% of it or $100K. Which fund(s) would you decide to recharacterize?

Example 4. On the day you convert, you open a new (empty) Roth and you convert $100K of fund MM into it. The conversion is 100% of the account's value. When you find out that the taxes on the conversion are more than you expected, you decide to recharacterize. Regardless if the account value has changed or not, if you recharacterize the whole conversion, 100% of the account value will be removed.

Example 5. Same as example 4, but you can afford the taxes. However, the money was invested in a stock fund which lost half of its value. Do you still want to pay taxes on a $100K conversion that is now only worth $50K?

Is there a way out of this that has a happy ending?

Well, I don't know if you would call it a "happy ending", but if the account value fell to the same value it was on the day you converted, THEN you could remove exactly $100K. If the account value fell even more, you would remove less than that dollar amount.

Since the recharacterization must be done before October 15 of this year, either is a possibility. If you do decide to wait, I suggest you don't wait past October 1 since things get very busy at most custodians because of last-minute recharacterizations. As I recall, you also need to report the original dollar amount that was converted and recharacterized, along with the current value of the recharacterizaion (how many dollars were removed) as of the day the recharacterization was done. And the tax return with this information must still be submitted by October 15.


hushpuppy wrote:Mystified, because you have not yet re-characterized, I am wondering if you could transfer the Roth assets you do not want to re-characterize to a different custodian and then re-characterize just the portion of the money market fund that you desire. (Effectively isolating Roth assets, before re-characterization) Or, so as not to disturb your previous Roth positions, transfer the Roth money market fund to another custodian and re-characterize the Roth money market fund after the transfer is complete. I realize this would not be ideal and I would consult with more knowledgeable bogleheads before proceeding.

Hushpuppy, This does not work since the additions and withdrawals done between the date of conversion and date of recharacterization have to be taken into account. There will not be enough left in the account to do the full conversion recharacterization and the OP would have to pay taxes on the part that couldn't be recharacterized. If you choose one of my above examples where 33.33% of the account value has to be removed, do you somehow think that after withdrawing the non-MM funds, only 33.33% of the remaining (partial) conversion will be removed? That goes against all the rules.

If something like that was possible, everyone would withdraw 99% of the account (even if the account contained only the converted amount and its growth/loss), and pay 1% of the owed taxes. Besides that, the IRS will know you tried to do this because the custodians send the IRS (and you) a Form 1099-R the following January to report IRA transfers, Roth conversions, and recharacterizations. They will wonder why you aren't paying taxes on the converted amount when there isn't a corresponding 1099-R for the recharacterization (it shows the value of the original conversion that was recharacterized, not the value on the day the recharacterization was done).
Last edited by celia on Sat May 20, 2017 7:12 pm, edited 1 time in total.
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Sat May 20, 2017 7:38 am

Celia wrote:

Hushpuppy, This does not work since the additions and withdrawals done between the date of conversion and date of recharacterization have to be taken into account. There will not be enough left in the account to do the full conversion and the OP would have to pay taxes on the part that couldn't be recharacterized. If you choose one of my above examples where 33.33% of the account value has to be removed, do you somehow think that after withdrawing the non-MM funds, only 33.33% of the remaining (partial) conversion will be removed? That goes against all the rules.

If something like that was possible, everyone would withdraw 99% of the account (even if the account contained only the converted amount and its growth/loss), and pay 1% of the owed taxes. Besides that, the IRS will know you tried to do this because the custodians send the IRS (and you) a Form 1099-R the following January to report IRA transfers, Roth conversions, and recharacterizations. They will wonder why you aren't paying taxes on the converted amount when there isn't a corresponding 1099-R for the recharacterization (it shows the value of the original conversion that was recharacterized, not the value on the day the recharacterization was done).


Celia, as far as I can see the required 1099s would not prevent this transfer of custodian idea from working. The entire amount of the money market Roth could be re-characterized. The system would not be "gamed" as you seem to think. This idea would be to pay the taxes only for the amount recently converted and the associated gains from that particular money market conversion. This would be the exact outcome you yourself would experience on your mutual fund platform that happens to have uniquely identified account numbers. This situation for those who don't happen to have uniquely numbered accounts is a land mine that maims the unsuspecting. If you don't mind, I would like for bogleheads perhaps less concerned about punishing an honest mistake to weigh in.

Have a nice day. :)

Regards to all,

hushpuppy
Last edited by hushpuppy on Sat May 20, 2017 1:42 pm, edited 1 time in total.

Chip
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby Chip » Sat May 20, 2017 8:10 am

hushpuppy wrote:Celia, as far as I can see the required 1099s would not prevent this transfer of custodian idea from working. The entire amount of the money market Roth could be re-characterized.


I'm sure celia will be along shortly to show you in detail why what you suggest won't work (she's already given you the short version).

But here's another stab at it. If OP transfers the 100k money market to a new Roth, then instructs the custodian to recharacterize that entire account, the custodian will report that $89,286 of the original conversion was recharacterized, along with $10,714 of earnings. This is because of the rules that celia discussed in her post.

It may be a tax land mine, but it's the law. Ignorance of the law is rarely a viable excuse.

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Sat May 20, 2017 8:52 am

Chip wrote:

hushpuppy wrote:
Celia, as far as I can see the required 1099s would not prevent this transfer of custodian idea from working. The entire amount of the money market Roth could be re-characterized.


I'm sure celia will be along shortly to show you in detail why what you suggest won't work (she's already given you the short version).

But here's another stab at it. If OP transfers the 100k money market to a new Roth, then instructs the custodian to recharacterize that entire account, the custodian will report that $89,286 of the original conversion was recharacterized, along with $10,714 of earnings. This is because of the rules that celia discussed in her post.

It may be a tax land mine, but it's the law. Ignorance of the law is rarely a viable excuse.


It is not obvious to me that the new custodian would know what the portion of the Roth money market transfer received was compared to the entire Roth at the original custodian. However, I have no knowledge about the details of how all of this actually works. Therefore, I seek information to alleviate my ignorance.

[OT comment removed by moderator prudent] I enjoy positive usually knowledgeable responses to a given topic here at bogleheads. I recognize my own viewpoint/expectations may be in need of realignment.

Regards to all,

hushpuppy

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby cherijoh » Sat May 20, 2017 9:03 am

[OT comment removed by moderator prudent]

Chip wrote:
hushpuppy wrote:Celia, as far as I can see the required 1099s would not prevent this transfer of custodian idea from working. The entire amount of the money market Roth could be re-characterized.


I'm sure celia will be along shortly to show you in detail why what you suggest won't work (she's already given you the short version).

But here's another stab at it. If OP transfers the 100k money market to a new Roth, then instructs the custodian to recharacterize that entire account, the custodian will report that $89,286 of the original conversion was recharacterized, along with $10,714 of earnings. This is because of the rules that celia discussed in her post.

It may be a tax land mine, but it's the law. Ignorance of the law is rarely a viable excuse.


+1

OP is learning an expensive lesson about making impulsive decisions that have tax consequences.

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby LadyGeek » Sat May 20, 2017 11:30 am

hushpuppy has been kind enough to suggest changes to the wiki.

Can the experts please provide suggestions in this topic? [Wiki] - Pro-rata rule impact on Roth IRA recharacterization
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby Chip » Sat May 20, 2017 2:58 pm

hushpuppy wrote:It is not obvious to me that the new custodian would know what the portion of the Roth money market transfer received was compared to the entire Roth at the original custodian. However, I have no knowledge about the details of how all of this actually works. Therefore, I seek information to alleviate my ignorance.


In this post you mentioned Treasury Reg 1.408A-5, Q&A-2(c)(4).

That same regulation has the paragraph that celia was referring to [1.408A-5(c)(2)(ii)]. In computing the adjusted closing balance of the conversion, it says:

(ii) The term adjusted closing balance means the fair market value of the IRA at the end of the computation period plus the amount of any distributions or transfers (including contributions returned pursuant to section 408(d)(4) and recharacterizations of contributions pursuant to section 408A(d)(6)) made from the IRA during the computation period.

So the amount of the transfer into the new Roth would have to be added to the balance in the original Roth to as part of the process in determining the gain on the conversion. So the transfer could not accomplish what you proposed.

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby Alan S. » Sat May 20, 2017 4:02 pm

The IRS summarized the intent for the entire account gain/loss to apply in TD 9056 (2003) as copied here:

The final regulations retain the rule, without modification, that net income calculations
and allocations must be based on the overall value of an IRA and the dollar amounts
contributed, distributed or recharacterized to or from the IRA. Even in a recharacterization of
an amount converted to a Roth IRA where the Roth IRA contains both regular contributions
and conversion contributions, the final regulations do not permit net income, including any
losses, to be allocated other than pro rata. Thus, the principal amount of regular Roth IRA
contributions cannot be protected against adjustment for their pro rata share of net income,
including any net losses, during the computation period. Once contributions are commingled
in an account, those dollars are no longer associated with particular assets or contributions.
In the absence of maintaining separate accounts, tying particular assets to a particular
contribution would create administrative problems for taxpayers, IRA providers and the IRS.



However, the IRS Regs applying to recharacterized contributions do not attempt to deal with unlimited scenarios that can be created by transfers between accounts. The following is as detailed as they get per 1.408(A)-5 Q 7:

Q-7. If an amount is initially contributed to an IRA for a taxable year, then is moved (with net income attributable to the contribution) in a tax-free transfer to another IRA (the FIRST IRA for purposes of A-1 of this section), can the tax-free transfer be disregarded, so that the initial contribution that is transferred from the FIRST IRA to the SECOND IRA is treated as a recharacterization of that initial contribution?

A-7. Yes. In applying section 408A(d)(6), tax-free transfers between IRAs are disregarded. Thus, if a contribution to an IRA for a year is followed by one or more tax-free transfers between IRAs prior to the recharacterization, then for purposes of section 408A(d)(6), the contribution is treated as if it remained in the initial IRA. Consequently, an individual may elect to recharacterize an initial contribution made to the initial IRA that was involved in a series of tax-free transfers by making a trustee-to-trustee transfer from the last IRA in the series to the SECOND IRA. In this case the contribution to the SECOND IRA is treated as made on the same date (and for the same taxable year) as the date the contribution being recharacterized was made to the initial IRA.


The above only deals with total account transfers. If enough balance is left in the Roth account that received a conversion to fund the recharacterization under the net income attributed rules specified here https://www.law.cornell.edu/cfr/text/26/1.408-11, the recharacterization will get done but will not reflect gain/loss after the date of the transfer out. It will reflect gain or loss up to the date of the partial distribution or transfer out of the initial Roth.

Obviously, there are many cases where a transfer or distribution is done before a recharacterization is even contemplated. However, if a taxpayer intentionally does partial transfers with the intent to obfuscate the applicable IRS Regs by making it impossible for the Roth custodian to process the recharacterization, that taxpayer may end up with either no recharacterization and a full tax bill, or one where the custodian who now holds the bulk of the account improvises in a way that makes the situation worse. Custodians rarely cooperate with each other to simply process a recharacterization request. Some may improvise to a point, using their judgement as to whether they can obtain enough clear documentation to process a credible recharacterization calculation under the intent of the Regs, but keep in mind that the fact patterns for any particular taxpayer can vary widely.

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Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Sat May 20, 2017 4:20 pm

Chip wrote:

In this post you mentioned Treasury Reg 1.408A-5, Q&A-2(c)(4).

That same regulation has the paragraph that celia was referring to [1.408A-5(c)(2)(ii)]. In computing the adjusted closing balance of the conversion, it says:

(ii) The term adjusted closing balance means the fair market value of the IRA at the end of the computation period plus the amount of any distributions or transfers (including contributions returned pursuant to section 408(d)(4) and recharacterizations of contributions pursuant to section 408A(d)(6)) made from the IRA during the computation period.

So the amount of the transfer into the new Roth would have to be added to the balance in the original Roth to as part of the process in determining the gain on the conversion. So the transfer could not accomplish what you proposed.


For the OP's sake, I had hoped that there might be an "out" akin to back door Roths that seem to skirt the intent/spirit of applicable Roth laws, yet are lawful(?). You have convinced me that even in the OP's case, where his money market fund remained separate, there is no real alternative to pro-rated recharacterization. This remains a situation where separate unique account numbers are the only solution and is easily accomplished, if one only knows.

I was completely wrong in suggesting the possibility of custodian transfer.

Regards to all,

hushpuppy

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celia
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby celia » Sat May 20, 2017 7:08 pm

OK, I'm back. Someone asked LadyGeek for a wiki page(s) to be updated so this situation is prevented in the future, although we have talked about it in the forum before, over a year ago. That is a good suggestion, Hushpuppy. :) I went ahead and updated the Roth conversion wiki page (https://www.bogleheads.org/wiki/Roth_IRA_conversion). I did not see the need for updating any of the other IRA wiki pages. If you want to know why or have suggestions for the wiki page, please post them here: viewtopic.php?f=2&t=219336&p=3376448
and I will look at them later.

First, I made an error in my choice of words but don't think it changes the conversation:
hushpuppy wrote:Celia wrote:

Hushpuppy, This does not work since the additions and withdrawals done between the date of conversion and date of recharacterization have to be taken into account. There will not be enough left in the account to do the full conversion recharacterization and the OP would have to pay taxes on the part that couldn't be recharacterized. If you choose one of my above examples where 33.33% of the account value has to be removed, do you somehow think that after withdrawing the non-MM funds, only 33.33% of the remaining (partial) conversion will be removed? That goes against all the rules.

If something like that was possible, everyone would withdraw 99% of the account (even if the account contained only the converted amount and its growth/loss), and pay 1% of the owed taxes. Besides that, the IRS will know you tried to do this because the custodians send the IRS (and you) a Form 1099-R the following January to report IRA transfers, Roth conversions, and recharacterizations. They will wonder why you aren't paying taxes on the converted amount when there isn't a corresponding 1099-R for the recharacterization (it shows the value of the original conversion that was recharacterized, not the value on the day the recharacterization was done).

Celia, as far as I can see the required 1099s would not prevent this transfer of custodian idea from working. The entire amount of the money market Roth could be re-characterized. The system would not be "gamed" as you seem to think. This idea would be to pay the taxes only for the amount recently converted and the associated gains from that particular money market conversion. This would be the exact outcome you yourself would experience on your mutual fund platform that happens to have uniquely identified account numbers. This situation for those who don't happen to have uniquely numbered accounts is a land mine that maims the unsuspecting. If you don't mind, I would like for bogleheads perhaps less concerned about punishing an honest mistake to weigh in.

Second, if anyone thought I was suggesting someone would try to "game the system", that was not my intent. My intent was to show that if the suggestion was allowed, why wasn't everyone doing it? If my tone offended anyone, I apologize. I try to be efficient, sometimes too much so.

Someone thought my response to Hushpuppy was not the "detailed version". I didn't go into any more detail, since this doesn't really solve the OP's problem. But let's look at the proposed situation anyway.

There is nothing to prevent Mystified from moving all the assets except what he/she wants to recharacterize to another custodian. But that doesn't change the fact that $112K still needs to be removed (unless the account value changes some more before then). If $100K remains in the current Roth all by itself and is recharacterized, Mystified will still have to report a conversion of $100K followed by 89% of the original conversion being recharacterized ($100K/$112K). That leaves a conversion of $11K that will be taxed. The custodian will send a 1099-R for a $100K conversion and a 1099-R for a $89K-ish recharacterization (that is then worth $100K).

Mystified, Do you now see that the extra $12K is just part of the overall Roth account growth that occurred during the time the conversion money was in the Roth? The rest of the growth belongs to the original Roth holdings. So after you recharacterize, both the Roth and the traditional IRA come out ahead. Unfortunately, you will have to pay taxes on any amount that remains in the Roth if you don't withdraw enough.

I'm also surprised you did not invest the MM fund so that it would grow the same as the other assets in the Roth. Putting (and then leaving) cash in a Roth does not make much sense since the whole point is to grow your assets tax-free within the Roth. If it had grown and earned $12K on its own while the rest of the account grew similarly, would you have had a problem removing $112K?

edit: response to mystified.
Last edited by celia on Sat May 20, 2017 9:52 pm, edited 1 time in total.
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.

hushpuppy
Posts: 71
Joined: Fri Dec 18, 2015 2:33 pm

Re: Re-characterization of Roth contribution "opportunity" issue

Postby hushpuppy » Sat May 20, 2017 8:04 pm

Celia - Alan S., Chip, Michael Kitces and many others agree with what you have said. Thank you for working to improve the Wiki and to include a warning about the pro-rata Roth recharacterization issue. You obviously do care about the effects on the unsuspecting. My apologies for questioning your responses.

Regards,

hushpuppy

FactualFran
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby FactualFran » Sun May 21, 2017 1:12 pm

hushpuppy wrote:Mystified, because you have not yet re-characterized, I am wondering if you could transfer the Roth assets you do not want to re-characterize to a different custodian and then re-characterize just the portion of the money market fund that you desire. (Effectively isolating Roth assets, before re-characterization) Or, so as not to disturb your previous Roth positions, transfer the Roth money market fund to another custodian and re-characterize the Roth money market fund after the transfer is complete. I realize this would not be ideal and I would consult with more knowledgeable bogleheads before proceeding.

Here is another take on what others have already posted.

Transferring the Roth IRA assets that are to not be recharacterized does not negate the earnings the Roth IRA had between the conversion contribution and the transfer. Those earnings remain in the calculation of the income allocable to the amount being recharacterized.

Transferring the Roth IRA assests that are to be recharactered does not negate the earnings of the Roth IRA transferred from. The answer to question 7 in the Recharacterized contribution IRS regulations includes: "Thus, if a contribution to an IRA for a year is followed by one or more tax-free transfers between IRAs prior to the recharacterization, then for purposes of section 408A(d)(6), the contribution is treated as if it remained in the initial IRA."

Section 408A(d)(6) contains the provision about including in an amount recharacterized the income allocable to the contribution. In other words, the income allocable to a contribution is determined using the earnings rate of the "initial IRA".

One may not do the following sequence of actions
  1. make a traditional IRA to Roth IRA conversion contribution (to Roth IRA 1),
  2. do a tax-free transfer of the amount converted to another Roth IRA (Roth IRA 2),
  3. recharacterize from Roth IRA 2 to a traditional IRA the amount of the conversion contribution to Roth IRA 1,
  4. use as the income allocable to the amount converted the earnings during the (perhaps, very short) period that the amount converted was in Roth IRA 2,
and treat that as if the entire Roth conversion contribution has been recharacterized. The income allocable to the amount converted is determined using the earnings rate of Roth IRA 1, from immediately prior to when the conversion contribution was made to immediately prior to when the recharacterizing transfer was done.
Last edited by FactualFran on Mon May 22, 2017 2:03 pm, edited 2 times in total.

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celia
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Re: Re-characterization of Roth contribution "opportunity" issue

Postby celia » Mon May 22, 2017 4:02 am

hushpuppy wrote:Mystified, because you have not yet re-characterized, I am wondering if you could transfer the Roth assets you do not want to re-characterize to a different custodian and then re-characterize just the portion of the money market fund that you desire. (Effectively isolating Roth assets, before re-characterization) Or, so as not to disturb your previous Roth positions, transfer the Roth money market fund to another custodian and re-characterize the Roth money market fund after the transfer is complete. I realize this would not be ideal and I would consult with more knowledgeable bogleheads before proceeding.

The OP CAN recharacterize just the portion of the money market fund that he/she desires without doing any transfers to another Roth or custodian, although it won't be a recharacterization of the full conversion, just 89% of the conversion.

The OP CAN recharacterize any percentage of the original conversion he/she wants, including 0% of it or 100% of it.

The "problem" the OP has is that the original converted amount is now worth $112K, in the eyes of the IRS. So if 100% of the conversion is to be removed, that is the (current) dollar amount that would have to be removed. I assume that the OP does not like that idea because it means not only the MM holdings would be removed, but also a part of another fund. That is only an assumption. But the non-MM fund(s) now have a higher value than they did on conversion day, even after the $112K removal.
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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