Roth Conversion and Recharacterization [theory] ?

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WoodSpinner
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Roth Conversion and Recharacterization [theory] ?

Post by WoodSpinner » Mon Oct 02, 2017 3:38 pm

All,

I have reviewed the Wiki on Roth IRA Conversions and have a question on my first set of Conversions.

I have 2 IRA Accounts (IRA-A and IRA-B). Both contain shares of VTI that I want to convert into a Roth Account.

The Wiki advises:
The primary recommendation when you convert is to always convert into a new (empty) Roth. If you are converting multiple holdings (funds, stocks, bonds), put each one into a new, separate, empty Roth. This will allow you to specify what you want returned to the traditional IRA, should a recharacterization be needed.[/quote].

But I am not clear if I should create 2 Roth Accounts:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-B (y shares of VTI).

or if I can safely convert to a single Roth Account:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-A (y shares of VTI)

Advice is welcomed ....

Thanks

Joel
Last edited by WoodSpinner on Tue Oct 10, 2017 9:25 am, edited 1 time in total.

dbltrbl
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Re: Roth Conversion and Recharacterization ?

Post by dbltrbl » Mon Oct 02, 2017 3:44 pm

in your case, single account conversion is OK. You can re characterize part or all of it if needed.

retiredjg
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Re: Roth Conversion and Recharacterization ?

Post by retiredjg » Mon Oct 02, 2017 3:46 pm

You only need one new Roth IRA account for this.

The advice to have a new Roth stems from some peoples' desire to recharacterize their conversion if the market goes down before the end of the year.

Example: You convert $10k worth of something to Roth and by the end of the year it is only worth $8k. Why pay tax in that tax year on $10k instead of $8k? So they "recharacterize the conversion" (make it like it never happened), avoid the taxes, and convert to Roth again at some later date.

Since apparently you are only interested in converting money that is invested in 1 ETF, even from two separate accounts, just having 1 Roth IRA is fine.

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CAsage
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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Mon Oct 02, 2017 3:52 pm

The Wiki is unnecessarily strict on the 'open a new account every time" rule. What really bites you in the behind is having a destination Roth IRA with more than one kind of asset in it - because if you recharacterize they prorate the $$ from both winners and losers (and you can't specify). To protect your options, convert into a Roth with only one fund or ETF in it. I happen to have several Roth IRA, one Total Stock, one Total International, one Total bond and I reuse them as needed to convert annually....

Since you want to keep it all in VTI, one Roth is fine.
Salvia Clevelandii "Winifred Gilman" my favorite. YMMV; not a professional advisor.

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Mon Oct 02, 2017 3:56 pm

Most Excellent -- thanks for the feedback.

Just submitted the paperwork.

:sharebeer

hushpuppy
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Re: Roth Conversion and Recharacterization ?

Post by hushpuppy » Tue Oct 03, 2017 2:19 pm

I agree with the other posters to this thread. However, I would like to give an extreme example for the "trap" that the Wiki wording avoids. This is only intended for those who are not already fully aware of this potential "trap".

Example: An individual has held a Roth account, since they were allowed in 1998. Consider that one could have invested in the Vanguard Total Stock Market fund until this year's conversion, worth $170,000. This year for whatever reason one chooses to convert to a Roth $10,000 in a REIT mutual fund. Say this hypothetical REIT mutual fund declines to $5,000. Meanwhile the Vanguard Total Stock Market fund Roth gained $25,000. The smart move would be to re-characterize the Roth $10,000 in a REIT mutual fund. If a completely separate (uniquely numbered) Roth had been created, then re-characterization of the remaining $5,000 of REIT mutual fund returns one to the previous taxes owed condition, prior to the REIT conversion. If a separate (uniquely numbered) Roth account had not been used, then a prorated $10,000 across the whole Roth account would be applied for re-characterization. This would prevent re-characterization for tax purposes, because there would not be a loss, considering the Roth account in its entirety.

I'm not sure that my example has clarified my concern of anyone being victimized by this re-characterization "trap".

Regards,

hushpuppy

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Tue Oct 03, 2017 4:15 pm

Thanks for the additional example. I think the WIKI did a good job of illustrating why this was important.

8-)

hushpuppy
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Re: Roth Conversion and Recharacterization ?

Post by hushpuppy » Tue Oct 03, 2017 7:24 pm

WoodSpinner wrote:
Tue Oct 03, 2017 4:15 pm
Thanks for the additional example. I think the WIKI did a good job of illustrating why this was important.

8-)
That is a good thing. Boglehead celia recently updated that section of the Wiki. I'm guessing she will be pleased to know her efforts have helped. 8-)

Regards,

hushpuppy

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Tue Oct 03, 2017 8:50 pm

:happy , certainly not the first, nor hopefully the last time I have benefited from Celia's insights and efforts.

She is certainly one of the reasons, I am doing the Roth Conversions in the first place. There was a long and spirited thread to convince me of the wisdom of paying taxes now, to avoid taxes later.

I put in my Retirement papers today and did my first conversion. Plan is to finish out the year and start the next chapter in 2018. :sharebeer

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Wed Oct 04, 2017 7:47 pm

Okay, I have a follow-up just to be sure I am doing this right ...

I am still employed for 2017 but completed my first Roth Conversion in October. Normally I do not need to worry about Est Tax payments, my withholding is sufficient.

The Conversion however will require me to make an additional Estimated Tax Payment (Jan 16, 2018).

Assuming I pay enough in this Est tax payment that will cover my expected tax bill for 2017....

I should be under safe-harbor, even if I didn't make Estimated payments previously this year.

Am I interpreting the rules correctly?

Thanks

Joel

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Epsilon Delta
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Re: Roth Conversion and Recharacterization ?

Post by Epsilon Delta » Wed Oct 04, 2017 11:16 pm

WoodSpinner wrote:
Wed Oct 04, 2017 7:47 pm
Okay, I have a follow-up just to be sure I am doing this right ...

I am still employed for 2017 but completed my first Roth Conversion in October. Normally I do not need to worry about Est Tax payments, my withholding is sufficient.

The Conversion however will require me to make an additional Estimated Tax Payment (Jan 16, 2018).

Assuming I pay enough in this Est tax payment that will cover my expected tax bill for 2017....

I should be under safe-harbor, even if I didn't make Estimated payments previously this year.

Am I interpreting the rules correctly?

Thanks

Joel
A single fourth quarter estimated payment cannot help you find a safe harbor. Only estimated payments paid equally in the four quarters (or earlier) and withholding count under the safe harbor rules.

If your income is uneven (e.g. because of a fourth quarter Roth conversion) a single fourth quarter estimated tax can avoid a penalty, but this is not a safe harbor; you need to file form 2210 and Schedule AI to document the uneven income.

Schedule AI is essentially a mini-tax return for each quarter. If you have a simple life and keep good records it may not be too bad but it can be a bear, a rabid bear, with an Uzi. Most advisors would suggest increasing withholding for the last few months of 2017 instead of making an estimated payment. Unlike estimated payments, withholding counts towards the safe harbors even if it is uneven

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celia
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Re: Roth Conversion and Recharacterization ?

Post by celia » Thu Oct 05, 2017 3:00 am

CAsage wrote:
Mon Oct 02, 2017 3:52 pm
The Wiki is unnecessarily strict on the 'open a new account every time" rule.
Come on, Sage. It is a clear way of telling people what should be done without have to worry about all the ands, ifs, and buts. For example, look how convoluted the answer to this problem can be:
WoodSpinner wrote:
Mon Oct 02, 2017 3:38 pm
... I am not clear if I should create 2 Roth Accounts:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-B (y shares of VTI).

or if I can safely convert to a single Roth Account:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-A (y shares of VTI)
Advice 1:
There is an important criterion to determine if you should convert into one Roth or two, in this example. IF you are going to do both conversions in the same day AND have the same destination fund/ETF, then the cost of the shares from IRA-A and IRA-B will be the same on that day. The total value of both Roths or the single Roth will be the same on any day in the future. Therefore, you will get the same result whether you convert into one or two Roths. BUT IF you are going to do both conversions on different days when the value of a share is not likely to be the same on both days, then it is best IF you convert into two Roths. IF the same amount of money is coming out of both IRAs, the taxes will be the same either way BUT one conversion will allow more shares to be converted than the other. AND IF the same number of shares is coming out of both IRAs, the taxes will be different for each conversion. In this case, you may want to recharacterize the conversion that was not as advantageous for you.

Advice 2 (from the wiki):
The primary recommendation when you convert is to always convert into a new (empty) Roth. If you are converting multiple holdings (funds, stocks, bonds), put each one into a new, separate, empty Roth. This will allow you to specify what you want returned to the traditional IRA, should a recharacterization be needed.
.


WoodSpinner, It looks like you did your projections of taxes for the years between now and when you turn 70. Good for you! I figured you would be able to handle it. Were you surprised to see what would happen between now and then if you didn't start converting?

As far as your safe harbor question, Publication 17 says:
Estimated tax safe harbor for higher income taxpayers. If your 2016 adjusted gross income was more than $150,000 ($75,000 if you are married filing a separate return), you must pay the smaller of 90% of your expected tax for 2017 or 110% of the tax shown on your 2016 return to avoid an estimated tax penalty.
(Search for "safe harbor" on that page.)

Enjoy your retirement. I expect you will have more time available to spend in this forum next year. We can use your help. :beer

livesoft
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Re: Roth Conversion and Recharacterization ?

Post by livesoft » Thu Oct 05, 2017 5:46 am

WoodSpinner wrote:
Wed Oct 04, 2017 7:47 pm
I am still employed for 2017 but completed my first Roth Conversion in October. Normally I do not need to worry about Est Tax payments, my withholding is sufficient.

The Conversion however will require me to make an additional Estimated Tax Payment (Jan 16, 2018).

Assuming I pay enough in this Est tax payment that will cover my expected tax bill for 2017....
Since you are still working for the rest of 2017, I would suggest that you simply adjust your tax withholding on your paycheck (aka W-2 income) by submitting a new W-4 to your employer, so that the additional tax is paid. That way you shouldn't have to file an estimated tax return.

I guess if you convert so much that your paychecks won't have enough income in them to cover the extra tax, then you might not want to do that.
This signature message sponsored by sscritic: Learn to fish.

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Thu Oct 05, 2017 9:25 am

celia wrote:
Thu Oct 05, 2017 3:00 am

WoodSpinner, It looks like you did your projections of taxes for the years between now and when you turn 70. Good for you! I figured you would be able to handle it. Were you surprised to see what would happen between now and then if you didn't start converting?
I have built a very useful model in Excel to manage my Income, Expense, and Taxes throughout my retirement. The tax calculations are a bit of a SWAG for a variety of reasons (e.g. unknown future rates, AMT etc.) but they provide a reasonable accurate prediction (especially 1 year out).

It's very clear that doing Roth Conversions now will save me taxes in the future (assuming I live as long as the model predicts :D ) and will end up with a Portfolio of greater value. I modeled a number of scenarios:

1. No Conversions at all
2. Minimum amount of conversions to support my retirement income needs through 70 1/2.
3. Conversions to the top of the 25% bracket
4. Conversions to an 23% Effective Tax Rate

I am moving forward with Option 4 since it brings the average Effective Tax Rate during early retirement (58-69) within a few percentage points of the average Effective Tax Rate during the later part of retirement (70-90). This results in the lowest projected Tax Expense and the highest adjusted portfolio value. As part of my Retirement Policy Statement I lay out the approach, timelines, validation, and adjustments to make sure what I model is as accurate as possible as I move forward in retirement.

celia wrote:
Thu Oct 05, 2017 3:00 am
As far as your safe harbor question, Publication 17 says:
Estimated tax safe harbor for higher income taxpayers. If your 2016 adjusted gross income was more than $150,000 ($75,000 if you are married filing a separate return), you must pay the smaller of 90% of your expected tax for 2017 or 110% of the tax shown on your 2016 return to avoid an estimated tax penalty.
(Search for "safe harbor" on that page.)

Enjoy your retirement. I expect you will have more time available to spend in this forum next year. We can use your help. :beer
My FIRE date is December 2017 -- my paperwork is in, and I am in countdown and wrap-up mode. I am really excited about what this next phase of life will bring.

Seems like things are tracking well.

Thanks for to all for their advice and help -- I certainly needed the help.

:sharebeer

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CAsage
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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Thu Oct 05, 2017 10:03 am

celia wrote:
Thu Oct 05, 2017 3:00 am
CAsage wrote:
Mon Oct 02, 2017 3:52 pm
The Wiki is unnecessarily strict on the 'open a new account every time" rule.
Come on, Sage. It is a clear way of telling people what should be done without have to worry about all the ands, ifs, and buts. For example, look how convoluted the answer to this problem can be:
WoodSpinner wrote:
Mon Oct 02, 2017 3:38 pm
... I am not clear if I should create 2 Roth Accounts:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-B (y shares of VTI).

or if I can safely convert to a single Roth Account:
1. IRA-A --> Roth-A (x shares of VTI)
2. IRA-B --> Roth-A (y shares of VTI)
Advice 1:
There is an important criterion to determine if you should convert into one Roth or two, in this example. IF you are going to do both conversions in the same day AND have the same destination fund/ETF, then the cost of the shares from IRA-A and IRA-B will be the same on that day. The total value of both Roths or the single Roth will be the same on any day in the future. Therefore, you will get the same result whether you convert into one or two Roths. BUT IF you are going to do both conversions on different days when the value of a share is not likely to be the same on both days, then it is best IF you convert into two Roths. IF the same amount of money is coming out of both IRAs, the taxes will be the same either way BUT one conversion will allow more shares to be converted than the other. AND IF the same number of shares is coming out of both IRAs, the taxes will be different for each conversion. In this case, you may want to recharacterize the conversion that was not as advantageous for you.

Advice 2 (from the wiki):
The primary recommendation when you convert is to always convert into a new (empty) Roth. If you are converting multiple holdings (funds, stocks, bonds), put each one into a new, separate, empty Roth. This will allow you to specify what you want returned to the traditional IRA, should a recharacterization be needed.
.
I respectfully disagree. The questions raised in your hypothetical Advice 1 seem to be creating issues where none exist. Your solution parallels telling people to open a new account every time they purchase taxable shares, so that they capital gains can be clearly tracked. There are existing ways to track capital gains, and there are existing and simple processes to recharacterize different lots of shares purchased on any given day at any given price. The Vanguard form for recharacterizing allows you to clearly specify which transaction on which date you want to undo. I have done so. I plan to continue my successful use of the one fund Roth for multiple annual conversions and recharacterizations as needed. That is a valid implementation, especially for someone holding only 2~3 basic funds in a Roth. Simplicity is a virtue.

The truly critical piece of information here is that each Roth should contain ONLY ONE ASSET - the number that an investor opens is just implementation, and a new account every time is by no means the only solution to the IRS "problem" of recharacterizing across all assets in account (should one make that mistake). I believe this blog serves to educate investors, and they should know WHY a new account works, and what the options are. Please don't rip people who happen to disagree or expand upon your posts.

Edited 10/6: Further discussion below has shown (me)that there are risks even in having one Roth IRA with multiple conversions at different price points, even with the same asset, and some people (me and ??) are trying to slog through some examples to see how that works. Here be dragons.
Last edited by CAsage on Fri Oct 06, 2017 11:52 am, edited 4 times in total.
Salvia Clevelandii "Winifred Gilman" my favorite. YMMV; not a professional advisor.

retiredjg
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Re: Roth Conversion and Recharacterization ?

Post by retiredjg » Thu Oct 05, 2017 10:04 am

Keep the IRMAA limits in mind after you start Medicare - going to the top of a tax bracket might put you into the position of paying more for the Medicare parts you decide to pay for.

WoodSpinner
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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Thu Oct 05, 2017 10:41 am

retiredjg wrote:
Thu Oct 05, 2017 10:04 am
Keep the IRMAA limits in mind after you start Medicare - going to the top of a tax bracket might put you into the position of paying more for the Medicare parts you decide to pay for.
I appreciate the advice and have included this and SS impact in the model. Even with these hits to the Marginal Tax Rates, I seem to be much better off using the approach I have laid out based on average Effective Taxes.

Thanks

8-)

Chip
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Re: Roth Conversion and Recharacterization ?

Post by Chip » Thu Oct 05, 2017 10:58 am

CAsage wrote:
Thu Oct 05, 2017 10:03 am
The truly critical piece of information here is that each Roth should contain ONLY ONE ASSET - the number that an investor opens is just implementation, and a new account every time is by no means the only solution to the IRS "problem" of recharacterizing across all assets in account (should one make that mistake). I believe this blog serves to educate investors, and they should know WHY a new account works, and what the options are. Please don't rip people who happen to disagree or expand upon your posts.
Your method of implementation certainly works to avoid recharacterization problems, and avoids the need to open new accounts. However, it does require that the assets in each of the conversion accounts never be changed, rebalanced, or transferred to other accounts. It also negates one's ability to use the "leapfrog" method making optimal conversions. In my own situation your method would be quite a straightjacket.

Right now I have 3 Roth accounts; one "mother" Roth plus two conversion Roths. Each conversion Roth has a single asset. Let's say the market now drops 15% below my conversion price for those assets and I want to convert again. How do I do that with your method while still preserving my ability to recharacterize in an efficient manner?

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CAsage
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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Thu Oct 05, 2017 11:14 am

Chip wrote:
Thu Oct 05, 2017 10:58 am

Your method of implementation certainly works to avoid recharacterization problems, and avoids the need to open new accounts. However, it does require that the assets in each of the conversion accounts never be changed, rebalanced, or transferred to other accounts. It also negates one's ability to use the "leapfrog" method making optimal conversions. In my own situation your method would be quite a straightjacket.

Right now I have 3 Roth accounts; one "mother" Roth plus two conversion Roths. Each conversion Roth has a single asset. Let's say the market now drops 15% below my conversion price for those assets and I want to convert again. How do I do that with your method while still preserving my ability to recharacterize in an efficient manner?
Ooh! Cool! Exchange ideas, yes! Ok, to expand my personal situation, I have three Roth IRAs - one Total Stock, one International, one Total Bond (pretty simple, easy to live with). I convert a Whopping Chunk every January to the two Stock Roths. Because I've been at this for a few years... the Roth IRAs contain several years worth of prior conversions. I rebalance with a phone call to my devoted Vanguard rep, who moves chunks between Roth accounts - easy, no tax consequences. I always make sure to leave enough in each to do my planned recharacterization in December (by choice, I run annual frog races).
The way I handle the horse (frog?) race(s) is to initially convert Whopping Chunks to each account from my source traditional IRA in January, and if the market goes up, I recharacterize the losers back to Traditional in December (paying taxes on the one winner from January, set $$ but lower share price).
Should the market go down (and I'm thinking we will get that chance...) I would convert (for example) $10k in January, and then with any significant market dip, I would do another $10K conversion to that same Roth account/Fund. At the end of the year, I recharacterize all the higher priced lots by specifying the shares and dates on the recharacterization forms. Note that you need multiple times $$ in the original source traditional IRA to do this, so lots of money in flux. Be very careful to track it and undo it, or you will have a massive tax hit. There are rules on conversions/recharacterization timing; caution is advised.

Thinking about it - the ability to recharacterize specific shares by date in a Roth IRA is critical to this implementation. We have not had a down market for me to test this (my prior rechacterizations were to lower taxable conversions, since everything went up). Looking at the Vanguard "Authorization to Recharacterize" Section 3, it appears you would have to submit one form for every conversion you wanted to undo. If that does not work, then Celia gets flowers and I eat crow.
Salvia Clevelandii "Winifred Gilman" my favorite. YMMV; not a professional advisor.

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Epsilon Delta
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Re: Roth Conversion and Recharacterization ?

Post by Epsilon Delta » Thu Oct 05, 2017 11:38 am

CAsage wrote:
Thu Oct 05, 2017 11:14 am
Ooh! Cool! Exchange ideas, yes! Ok, to expand my personal situation, I have three Roth IRAs - one Total Stock, one International, one Total Bond (pretty simple, easy to live with). I convert a Whopping Chunk every January to each. Because I've been at this for a few years... the Roth IRAs contain several years worth of prior conversions. I rebalance with a phone call to my devoted Vanguard rep, who at my command will move chunks between Roth accounts - easy, no tax consequences. I always make sure to leave enough in each to do my planned recharacterizations in December (by choice, I run annual frog races).
The way I handle the horse (frog?) race(s) is to initially convert Whopping Chunks to each account from my source traditional IRA in January, and if the market goes up, I recharacterize the lesser horses back to Traditional in December (paying taxes on the one winner from January, set $$ but lower share price).
Should the market go down (and I'm thinking we will get that chance...) I would convert (for example) $10k in January, and then with any significant market dip, I would do another $10K conversion to that same Roth account/Fund. At the end of the year, I recharacterize all the higher priced lots by specifying the shares and dates on the recharacterization form. Note that you need multiple $$ in the original source traditional IRA to do this, so lots of money in flux. Be very careful to track it and undo it, or you will have a massive tax hit.
In this situation any re-balancing interacts with recharacterization to give a different result than if there is no re-balancing in the recharacterized account. The difference is likely to be small, and It might be better or worse, but it will be different. This is because any transactions between the contribution and the recharacterization are accounted for at their nominal value and do not take into account changes in asset pricing.
You will also get similar effects if the contribution/recharacterization cycles for two tax years overlap, which they can do since the recharacterization can (and ideally should) be done 10 1/2 months after the end of the tax year.

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Re: Roth Conversion and Recharacterization ?

Post by Chip » Thu Oct 05, 2017 1:06 pm

CAsage wrote:
Thu Oct 05, 2017 11:14 am
Thinking about it - the ability to recharacterize specific shares by date in a Roth IRA is critical to this implementation. We have not had a down market for me to test this (my prior rechacterizations were to lower taxable conversions, since everything went up). Looking at the Vanguard "Authorization to Recharacterize" Section 3, it appears you would have to submit one form for every conversion you wanted to undo. If that does not work, then Celia gets flowers and I eat crow.
I'm pretty sure this isn't going to work, despite your ability to specify the conversion date (FYI, I've been doing this since 2003). But I'll be glad to be corrected on my understanding of the calculations.

Let's take a simple example, starting with an empty Roth: You convert 10k on Jan 1. On July 1 it has dropped in value to 5k, so you convert another 10k into the same Roth. By Dec 31 the asset has recovered to its Jan 1 price, so the value of the account is now 30k.

You decide you only want to pay tax on 10k of conversions, so you tell Vanguard to recharacterize the entire Jan 1 conversion. IRS rules say that they have to calculate the gain on the conversion by comparing the ratio of the adjusted opening balance (AOB) to the adjusted closing balance (ACB).

AOB is calculated as the balance of the account the day before the conversion being recharacterized was made, plus any conversions after that date. In the example this is 0+10+10 = 20k (zero opening balance plus 2 conversions of 10k each). The ACB is the balance on the date of recharacterization, less plus any distributions or other recharacterizations (none in this case). So the ACB is 30k.

The gain on your Jan 1 conversion is calculated as (ACB-AOB)/ACB - 1 = (30-20)/30 - 1 = 33.33%

The percentage gain on your Jan 1 conversion is calculated as (ACB-AOB)/AOB = (30-20)/20 = 50%

To recharacterize your 10k Jan 1 conversion Vanguard will remove 13,333 15,000 from your Roth and send it back to your tIRA.

This won't happen if each conversion went into a separate Roth, since the calculations are done separately for each Roth account.

1st edit: changed "less" to "plus" based on Epsilon Delta's comment below. No change in conclusions for this example.
2nd edit: more typos fixed & calculation modified based on celia's comment below.
Last edited by Chip on Sat Oct 07, 2017 7:20 am, edited 2 times in total.

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Epsilon Delta
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Re: Roth Conversion and Recharacterization ?

Post by Epsilon Delta » Thu Oct 05, 2017 1:17 pm

Chip wrote:
Thu Oct 05, 2017 1:06 pm
The ACB is the balance on the date of recharacterization, less any distributions or other recharacterizations (none in this case). So the ACB is 30k.
Technical correction:
The Adjusted Closing Balance (ACB) is the balance on the date of recharacterization increased by the amount of any distributions or other outflows.

This may depend on your sign convention, and of course the sign of zero does not matter in your example.

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Re: Roth Conversion and Recharacterization ?

Post by Chip » Thu Oct 05, 2017 1:20 pm

Epsilon Delta wrote:
Thu Oct 05, 2017 1:17 pm
Chip wrote:
Thu Oct 05, 2017 1:06 pm
The ACB is the balance on the date of recharacterization, less any distributions or other recharacterizations (none in this case). So the ACB is 30k.
Technical correction:
The Adjusted Closing Balance (ACB) is the balance on the date of recharacterization increased by the amount of any distributions or other outflows.

This may depend on your sign convention, and of course the sign of zero does not matter in your example.
Thanks. I wasn't paying close enough attention to wording. I will edit the original.

Chip
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Re: Roth Conversion and Recharacterization ?

Post by Chip » Thu Oct 05, 2017 1:44 pm

I should further note that a large beginning balance in the receiving Roth (relative to the conversion sizes) will dilute the effect shown in the example. So if we change the zero starting balance to 100k in the example, with the same two conversions, only 10,769 will have to be returned to the tIRA to recharacterize the entire Jan 1 conversion.

But it's still $769 of tax-free gain that is being forfeited by not using separate & empty Roths.

See 26 CFR 1.408-11- Net income calculation for returned or recharacterized IRA contributions for the detail on the calculations. Source here: https://www.law.cornell.edu/cfr/text/26/1.408-11

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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Thu Oct 05, 2017 3:23 pm

Fascinating! Prior examples I've seen discussed how a Roth with a mix of Asset A & B, where one went up and one went down, would result in the recharacterized amount being taken from both (bad), which of course is from that formula I had not seen before. So, it might not matter if I had only one Fund in the account; if it went up or down and I converted more into it ... it would take a prorated dollar and share regardless of my specifying the conversion date. Hmmm. I thought they would take the exact number of shares, and just reverse the original $$ value. Then, it sounds like I WILL need to open a daughter Roth IRA for every conversion next year.
To date, I have done multiple conversions and recharacterized small amounts to trim a little off the top of the tax bracket, but now I am retired and pre-SS, so I am in the zone for a lot of Roth conversions. I really want to handle a down market optimally. I suppose once the window on those recharacterizations runs out, I can consolidate.

Retired engineer - forgive my deep digging, but I really want to understand exactly how the dollar and share math works on this. I do my own taxes and manage my own accounts; I really need to understand. Does Vanguard truly use the IRS formula and ignore converted share dates?

Perhaps an example showing how my (former) solution can go bad in a dropping market could be added to the Wiki?
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Re: Roth Conversion and Recharacterization ?

Post by Chip » Thu Oct 05, 2017 4:00 pm

CAsage wrote:
Thu Oct 05, 2017 3:23 pm
Retired engineer - forgive my deep digging, but I really want to understand exactly how the dollar and share math works on this. I do my own taxes and manage my own accounts; I really need to understand. Does Vanguard truly use the IRS formula and ignore converted share dates?
I'm not a Vanguard customer but I know Fidelity follows the IRS method. Recharacterization letters I've received from them specifically refer to CFR 26 1.408-11.

I wouldn't say that they would ignore the conversion dates. If you take my earlier example and recharacterize the second conversion instead of the first you will get an AOB of 15k, since the AOB is calculated based on the account value on the day before the conversion being recharacterized was executed. Just an example of course -- no one would want to recharacterize the second conversion and retain the first.

Shares don't matter. Dollars matter.

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Re: Roth Conversion and Recharacterization ?

Post by celia » Thu Oct 05, 2017 5:19 pm

I've been working on examples and thinking about this thread for several hours.

CAsage, I was not trying to "rip" you or anyone else. I agree with you in that there are benefits in simplicity. But simplicity here does not just refer to holding a minimal number of assets (or using custodians). It also can refer to types of accounts/titling, tax status of each account (taxable, pre-tax, post-tax, mix), and thought processes. My earlier point was to show that the wiki made a simple warning for taxpayers that they could understand. What good is a warning if people don't understand it?

I've been trying to come up with an example to illustrate CAsage's situation of having each asset in a separate IRA. As of now, I agree with the method he/she is using, even if the markets go down. I was going to illustrate what a future conversion after a big stock market drop would do to the first conversion or what in-flows or out-flows to the other Roths that hold different assets would do to the Roth in question. But my analysis falls flat since I believe everything is based on percentage of the account value on the date of each conversion, in-flow, out-flow, or recharacterization is done. I couldn't find an official IRS "calculator" on how to handle CAsage's situation, so would appreciate it if someone could link to something official on the IRS website. If one is not found in the next day or two, I will show my example with actual numbers that we can discuss.
Chip wrote:
Thu Oct 05, 2017 4:00 pm
CAsage wrote:
Thu Oct 05, 2017 3:23 pm
Retired engineer - forgive my deep digging, but I really want to understand exactly how the dollar and share math works on this. I do my own taxes and manage my own accounts; I really need to understand. Does Vanguard truly use the IRS formula and ignore converted share dates?
I'm not a Vanguard customer but I know Fidelity follows the IRS method. Recharacterization letters I've received from them specifically refer to CFR 26 1.408-11.

I wouldn't say that they would ignore the conversion dates. If you take my earlier example and recharacterize the second conversion instead of the first you will get an AOB of 15k, since the AOB is calculated based on the account value on the day before the conversion being recharacterized was executed. Just an example of course -- no one would want to recharacterize the second conversion and retain the first.

Shares don't matter. Dollars matter.
I don't think CFR 26 1.408-11 will be applicable in this situation since it refers to contributions instead of conversions. They are very different in that contributions are limited to a specific dollar amount per specific time frame. Conversions are not. Recharacterizing a contribution into the other kind of IRA or for withdrawal makes sense to use the beginning and ending value of the time period. Recharacterizing a conversion back into the other kind of IRA is based on % of the IRA converted into. The same percent of the IRA converted into must be considered for recharacterizing conversions but other activities in that account also impact the value of the IRA so that needs to be considered too. So, does anyone know of an official source?

For this thread, shares don't matter. Dollars don't matter. Percents matter. (That was the give-away to me that the reference didn't apply.)

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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Thu Oct 05, 2017 8:10 pm

Celia, I have also been trying to digest what rules apply in this situation, and what multiple conversions (to either one account with a starting balance, or multiple conversion accounts, all one fund). Most examples I have read do not talk about doing multiple conversions over a year, prior to recharacterizing all but one of them, but I'm assuming that's legal and if you do it by December, you can start over in January. Beginning to regret whole idea....
I've tried a couple examples in excel, and the numbers get weird when "net income" is negative (as in you now have to take more shares because the year end value is lower than the prior balance). I would really like to understand it, and do it right.
I had felt the wiki blanket advice was not direct enough in pointing out the root IRS issue - which I thought was mixing assets in one account, but now I am wondering if it's really just mixing cost basis or share price (sort of...). Frankly, I can't tell if rechacterizing after a loss is better or worse in a combined or single account! I'm wrestling with that formula, and several examples, but I really don't know how the brokerage houses will calculate this. That might mean - just don't do it, since you cannot control it. :confused
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Re: Roth Conversion and Recharacterization ?

Post by Epsilon Delta » Thu Oct 05, 2017 9:54 pm

celia wrote:
Thu Oct 05, 2017 5:19 pm
I don't think CFR 26 1.408-11 will be applicable in this situation since it refers to contributions instead of conversions.
CFR 1.408A-4 A-1 (c) wrote: (c) Any converted amount is treated as a distribution from the traditional IRA and a qualified rollover contribution to the Roth IRA for purposes of section 408 and section 408A,
A qualified rollover contribution is a type of contribution, so 1.408-11 applies.

See also example 3. in Notice 2000-39 which made it clear that in 2000 this method also applied to "conversion contributions". Notice 2000-39 is not technically current, but IIRC it was adopted essentially without change by https://www.gpo.gov/fdsys/pkg/FR-2002-0 ... -07-23.pdf

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Re: Roth Conversion and Recharacterization ?

Post by CAsage » Fri Oct 06, 2017 11:29 am

Epsilon Delta, thank you! Then, I just need to wade through some examples to see how multiple conversions will play out in a declining market, with the assumption I recharacterize all except the last (lowest price) one..... and hope I model it right!
Celia, that formula gets you dollars, but they are based on fractions/ratios of the balance.... now just to figure out at what date to apply each balance! Yikes! Again, possibly so ugly that one should not attempt it.
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Re: Roth Conversion and Recharacterization ?

Post by Chip » Fri Oct 06, 2017 2:59 pm

CAsage wrote:
Fri Oct 06, 2017 11:29 am
Epsilon Delta, thank you! Then, I just need to wade through some examples to see how multiple conversions will play out in a declining market, with the assumption I recharacterize all except the last (lowest price) one..... and hope I model it right!
Celia, that formula gets you dollars, but they are based on fractions/ratios of the balance.... Yikes! Again, possibly so ugly that one should not attempt it.
I don't think you need to model it, at least for the simple leapfrog method with only one asset. As you mention above, the last conversion will always be the one you keep, and will be the one with the most gain. Therefore all AOBs and ACBs will include the conversion that is being kept. Including the gain of that conversion in the calculations will have to increase the percentage gain calculated for any previous conversion over its gain viewed in isolation.
now just to figure out at what date to apply each balance!
Per CFR 26 1.408-11 AOB is always calculated at a time immediately before the conversion being recharacterized took place. As a practical matter with mutual funds, it's the closing price the day before the conversion. I'm not sure what they do with ETFs.

There is no doubt in my mind that converting into an empty Roth is the best way to do this.

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Re: Roth Conversion and Recharacterization ?

Post by celia » Sat Oct 07, 2017 4:18 am

CAsage wrote:
Thu Oct 05, 2017 3:23 pm
So, it might not matter if I had only one Fund in the account; if it went up or down and I converted more into it ... it would take a prorated dollar and share regardless of my specifying the conversion date. Hmmm. I thought they would take the exact number of shares, and just reverse the original $$ value.
Since you keep referring to shares, let's say they have to take out not only the SHARES that were converted, but also the GROWTH on them (dividends, capital gains) which may be distributed as more shares. Then since a later conversion into the account (along with the original amount in the account) will grow more than if that first conversion hadn't happened, some of THAT GROWTH during the time the later conversion was in the account will also need to be removed!

But it is more correct to talk about the dollar value of the account, than about shares.
Then, it sounds like I WILL need to open a daughter Roth IRA for every conversion next year.
I suggest that even for this year, should the markets drop, you convert into a new (empty) Roth. That will keep your previous conversion simpler to recharacterize.
Does Vanguard truly use the IRS formula and ignore converted share dates?
Yes, every custodian has to follow IRS rules. Not, they don't ignore dates. They have to take into account the account value on the day before conversion and on the day before recharacterization. This has nothing to do with specific shares. (You can specify any asset in the account to be removed, such as if you changed the converted asset to another asset after the Roth conversion.)

I finally found the IRS's worksheet in Publication 590a, using worksheet 1-3. This worksheet looks easy to incorporate into a spreadsheet which I will do and post with some examples, probably tomorrow.
Perhaps an example showing how my (former) solution can go bad in a dropping market could be added to the Wiki?
I don't think it is limited to a dropping market. I will try to make an example showing how you have to remove more than you expect in an increasing market. If anything, the wiki should refer to an IRS pub and this thread since this will be too complicated/irrelevant for most users. I'd rather keep the wiki simpler. Right? :D
Last edited by celia on Sat Oct 07, 2017 6:21 am, edited 1 time in total.

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Re: Roth Conversion and Recharacterization ?

Post by celia » Sat Oct 07, 2017 6:15 am

Chip wrote:
Thu Oct 05, 2017 1:44 pm
See 26 CFR 1.408-11- Net income calculation for returned or recharacterized IRA contributions for the detail on the calculations. Source here: https://www.law.cornell.edu/cfr/text/26/1.408-11
Chip, Thank you for this link. After further research I retract my comment about contributions vs conversions. I find that the calculation for the "net Income" matches how the IRS does it in Worksheet 1-3 in Pub 590a, that I linked to above.

However, your use of it seems to have some some typos:
Chip wrote:
Thu Oct 05, 2017 1:06 pm
Let's take a simple example, starting with an empty Roth: You convert 10k on Jan 1. On July 1 it has dropped in value to 5k, so you convert another 10k into the same Roth. By Dec 31 the asset has recovered to its Jan 1 price, so the value of the account is now 30k.

You decide you only want to pay tax on 10k of conversions, so you tell Vanguard to recharacterize the entire Jan 1 conversion. IRS rules say that they have to calculate the gain on the conversion by comparing the ratio of the adjusted opening balance (AOB) to the adjusted closing balance (ACB).

AOB is calculated as the balance of the account the day before the conversion being recharacterized was made, plus any conversions after that date. In the example this is 0+10+10 = 20k (zero opening balance plus 2 conversions of 10k each). The ACB is the balance on the date of recharacterization, less plus any distributions or other recharacterizations (none in this case). So the ACB is 30k.

The gain on your Jan 1 conversion is calculated as (ACB-AOB)/ACB - 1 = (30-20)/30 - 1 = 33.33%

To recharacterize your 10k Jan 1 conversion Vanguard will remove 13,333 from your Roth and send it back to your tIRA.
First, the denominator of the ratio should be Adjusted Opening Balance (AOB), not ACB.
I also don't see where the "1" comes into play as you do the arithmetic, but know it represents the Value of the Conversion/Contribution on the day it was made
.
I was also curious about calculating how much would need to go back for the second conversion instead of/along with the first conversion. So, this is how I calculate it, using your example of two $10,000 conversions into an originally empty account:

To recharacterize Conversion 1 only:

AOB = 0 + 10,000 + 10,000 = 20,000
ACB = 30,000
Net Income = (30,000-20,000) / 20,000 = 0.5000 (this is $5,000 of growth on the $10,000 conversion).
To recharacterize, 10,000 + 5,000 = 15,000 would be removed.

To recharacterize Conversion 2 only:
AOB = 5,000 + 10,000 = 15,000
ACB = 30,000
Net Income = (30,000- 15,000) / 15,000 = 1.0000 (this is $10,000 of growth on the $10,000 conversion).
To recharacterize, 10,000 + 10,000 = 20,000 would be removed.

To recharacterize both Conversions at the same time:
This implies you would have to withdraw 15K + 20K out of a 30K Roth. But the reference link to Cornell (in the section that defines "Computation Period") says that:
If more than one contribution was made as a regular contribution and is being returned from the IRA, the computation period begins immediately prior to the time the first contribution being returned was contributed.
So if we were going to recharacterize both of them at the same time, they would both use the day before the first conversion. The calculation to recharacterize Conversion 1 would stay the same, but Conversion 2 would change to:

AOB = 0 + 10,000 + 10,000 = 20,000
ACB = 30,000
Net Income = (30,000-20,000)/ 20,000 = .5000 (this is $5,000 of growth on the $10,000 conversion).
To recharacterize, 10,000 + 5,000 = 15,000 would be removed.
So 15,000 removed from the 30,000 Roth for Conversion 1 and 15,000 removed from the Roth for Conversion 2, leaves the IRA empty. :D


Now let's see what happens if we recharacterize Conversion 1 and a few days later, we recharacterize Conversion 2 (keeping share values stable, to not confuse the examples)
Conversion 1 will have 15,000 removed as originally discussed. But the since the recharacterization date for Conversion 2 is now different, Conversion 2 has these calculations:
AOB = 5,000 + 10,000 = 15,000
ACB = (30,000-15,000 (Conversion 1 withdrawal)) + 15,000 (Conversion 1 withdrawal) = 30,000
Net Income = (30,000 - 15,000) / 15,000 = 15,000 / 15,000 = 1.0 (this is $10,000 of growth on Conversion 2)
To recharacterize, 10,000 + 10,000 = 20,000 would be removed for Conversion 2
So, to remove Conversion 1 followed by Conversion 2, 15,000 + 20,000 needs to be removed.


Now, let's reverse it and recharacterize Conversion 2 and a few days later, we recharacterize Conversion 1 (again, keeping share values stable).
Conversion 2 will have 20,000 removed per its original calculation.
Conversion 1 will have these calculations:
AOB = 0 + 10,000 + 10,000 = 20,000
ACB = (30,000-20,000 (Conversion 2 withdrawal)) + 20,000 (Conversion 2 withdrawal) = 30,000
Net Income = (30,000-20,000) / 20,000 = 0.5000 (this is $5,000 of growth on Conversion 1)
To recharacterize $10,000 + $5,000 = 15,000 needs to be removed.
So, to remove Conversion 2 followed by Conversion 1 on different days, 20,000 + 15,000 needs to be removed.


Conversion into new (empty) Roths
Before we close out this example, lets see what it would have looked like if each conversion had been put into a separate Roth. The first number is for Roth A, the second for Roth B. These Roths will have no co-mingling with each other.
(to keep some alignment of the numbers, periods will be used, but they represent spaces)
.........0 .........0 opening account values
10,000 .........0 contribution day for Roth A
..5,000 .........0 Really Bad Day(s)
..5,000 10,000 contribution day for Roth B
10,000 20,000 value of the asset returned to its original value (ie, it doubled)
At this point, if Conversion 1 would be recharacterized, 10,000 would need to be removed.
If Conversion 2 would be recharacterized, 20,000 would need to be removed.

Let me know if I did something wrong in my calculations. I know it is possible that the calculations could make more than 100% of the value of the conversions be removed. I know that if you covert into a new (empty) Roth and want to recharacterize it, no calculations are done and all of it is withdrawn. But if you convert into an account that has assets in it, it is possible to withdraw some of those pre-existing assets during the recharacterization.

Edit: Fixed the error in the calculations for recharacterizing Conversion 1, then Conversion 2.
Edit: Changed the text in the example for recharacterizing Conversion 2, then Conversion 1.
Edit: Added an example of doing each conversion into a new (empty) Roth.
Last edited by celia on Sat Oct 07, 2017 8:25 pm, edited 1 time in total.

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Re: Roth Conversion and Recharacterization ?

Post by Chip » Sat Oct 07, 2017 7:10 am

celia wrote:
Sat Oct 07, 2017 6:15 am
However, your use of it seems to have some some typos:

First, the denominator of the ratio should be Adjusted Opening Balance (AOB), not ACB.
I also don't see where the "1" comes into play as you do the arithmetic, but know it represents the Value of the Conversion/Contribution on the day it was made
Thanks for the corrections. I was clearly typing too fast and not proofing enough. I will go back to original and edit.

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Re: Roth Conversion and Recharacterization ?

Post by WoodSpinner » Sat Oct 07, 2017 10:48 am

Al,

Just want to give everyone a big thanks for this thread :) , it has morphed into a great learning experience for me and I hope for others.

:sharebeer

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