At The Ultimate Estate Planner, Inc. it’s important to us to keep our customers and the rest of the estate planning community informed about very important and exciting updates as it happens. A special thank you to Michelle Ward and Robert Keebler for this wonderful article featured on WealthManagement.com.
Roth IRA Conversion Recharacterization Permitted by Michelle L. Ward
Taxpayer relied on financial advisor’s advice
In Private Letter Ruling 201235030 (June 6, 2012), received by Keebler & Associates, the Internal Revenue Service granted the taxpayer an extension to recharacterize his 2009 Roth individual retirement account conversions.
In 2009, the taxpayer read articles and heard discussions describing the end of the $100,000 income limitation (which actually occurred in 2010) for converting to a Roth IRA and highlighting the benefits of performing such a conversion. He came under the mistaken impression that the income limitation was eliminated in 2009, rather than in 2010. Because the articles, generally, indicated that it was a good time to perform a conversion, due to the decline in the stock market, he decided to go forward with performing the Roth IRA conversions.
Also in 2009, before he performed the Roth conversions, the taxpayer consulted with his financial advisor, who was also his uncle, and discussed that he was considering performing a Roth IRA conversion. The financial advisor submitted an affidavit along with the PLR request, in which he represented that he has been advising the taxpayer and the taxpayer’s wife since 1998, that in 2009 the taxpayer discussed with him the idea of a Roth conversion, that he never informed the taxpayer the $100,000 limitation still applied in 2009, that his failure to inform the taxpayer was an oversight on his part and that the taxpayer relied on the financial advisor to inform them if a Roth conversion was either inadvisable or not allowable.
The taxpayer prepares his and his wife’s tax return annually without the assistance of a paid preparer. In 2009, he used software to prepare their income tax return, but due to a keystroke or entry error when completing the 2009 Form 1040, the Roth IRA conversion amounts he placed on line 15a didn’t carry over to line 15b. He didn’t realize this error had occurred when he filed their tax return. Because of this error, the taxpayer and his wife received an IRS Notice of Deficiency, increasing their income by the amount of the conversion. Upon receipt of this Notice, the taxpayer contacted an attorney for assistance, and it was during these conversations with that the taxpayer first discovered that he had been ineligible to make the 2009 Roth conversions, because his 2009 income exceeded $100,000.
For tax years beginning before 2010, a taxpayer is eligible to rollover funds from a traditional IRA to a Roth IRA provided that his: (1) adjusted gross income (AGI) was no more than $100,000, and (2) filing status wasn’t “married filing separately”.
To the extent that a taxpayer converted his traditional IRA to a Roth IRA and later found out that his AGI exceeded $100,000, the taxpayer could elect to recharacterize (that is, undo) the conversion. However, the recharacterization must have been completed on or before the due date of the federal income tax return (including extensions) for the year of conversion (that is, no later than October 15th would be constrained to the original conversion amount.
Notwithstanding the Oct. 15th deadline, under Treasury Regulations Section 301.9100-1(c), the IRS may grant a reasonable extension of time fixed by regulation, a revenue ruling, a revenue procedure, a notice or an announcement for making an election, which includes a Roth IRA recharacterization.
Treas. Regs. Section 301.9100-3 provides that applications for relief will be granted when the taxpayer provides sufficient evidence to establish that: (1) the taxpayer acted reasonably and in good faith; and (2) granting relief wouldn’t prejudice the interests of the government. The regulations provide that a taxpayer will be deemed to have acted reasonably and in good faith if, among other factors, the taxpayer reasonably relied on a qualified tax professional, and the tax professional failed to make, or advise the taxpayer to make, the election.
In this case, the IRS found that the information presented and documentation submitted by the taxpayer was consistent with his assertion that his failure to elect to recharacterize the Roth IRA on or before the due date was caused by his lack of awareness of the necessity of making an election, as a result of his reliance on his financial advisor.
Although one should never depend upon Treas. Regs. Section 301.9100-3 relief, this PLR provides some insight as to when such relief can be granted. It’s also a good reminder of the power of the recharacterization provisions. Although, in this instance, the recharacterization provisions applied when the taxpayer’s modified AGI exceeded $100,000, there’s nothing to prevent a recharacterization if the Roth IRA falls in value after the conversion or if the taxpayer’s financial circumstances change significantly.
The primary benefit of recharacterizations is that the taxpayer can assess the post-conversion returns and determine if the conversion was worthwhile in the first place. For example, let’s assume a taxpayer converts $100,000 to a Roth IRA in 2012. Now let’s assume that the value of the Roth IRA is $80,000 in March 2013. In this case, the taxpayer would simply recharacterize the conversion by moving the entire $80,000 Roth IRA back to a traditional IRA on or before the time he files his 2012 individual income tax return. The effect of the recharacterization is that the taxpayer won’t be taxed on any of the $100,000 original conversion, because he recharacterized the entire amount back to a traditional IRA.
The 2012 tax year is the perfect time to take advantage of converting to a Roth IRA before income tax rates go up in 2013. In many cases, taxpayers can easily achieve a “heads I win, tails I tie” situation, especially those who have sufficient wherewithal outside of their IRAs to pay the income tax liability on a Roth IRA conversion. In most cases, all post-conversion income and growth can be sheltered from future income tax, while any post-conversion losses can be made less painful by recharacterizing the prior conversion.