The Art of Roth Recharacterizations

roth-ira-recharacterizations-robert-keeblerBy Robert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA

For affluent taxpayers Roth Conversions provide a significant opportunity to move funds from a tax deferred environment (as is the case with traditional IRAs) into a tax-free environment (as is the case with Roth IRAs) at a relatively reasonable current income tax cost. In general, there are eight reasons why a person may want to consider converting to a Roth IRA:

  1. Special favorable tax attributes (e.g., charitable deduction carryforwards, net operating losses (NOLs), investment tax credits, excess itemized deductions, high basis nondeductible traditional IRAs, etc.) can be taken advantage of.
  1. The required minimum distribution (RMD) rules at age 70½ are suspended.
  1. Paying income tax on a Roth IRA conversion before paying estate tax is more tax efficient than paying estate tax first on a traditional IRA and then paying income tax on future traditional IRA distributions.
  1. For those having substantial non-qualified investment sources (i.e., “outside accounts”), using these sources to pay the income tax on a Roth IRA conversion will generally enhance overall future wealth.
  1. Roth IRAs are usually the best asset to fund bequests to non-spousal beneficiaries.
  1. Future Roth IRA distributions are generally income tax–free to beneficiaries.
  1. Converting to a Roth IRA during the joint lifetimes of married spouses is more tax efficient than taking traditional IRA distributions after one spouse dies (due to the differences between single and married filing jointly tax brackets).
  1. There is an ability to “recharacterize” (i.e., undo) prior Roth IRA conversions.

Of the eight reasons listed above, it appears right now, because of the worry of volatility in the stock market, the most important reason why a taxpayer may want to consider converting to a Roth IRA is the ability for him/her to “recharacterize” a prior Roth IRA conversion. In essence, under the tax law, a taxpayer has all the way up until October 15 of the year following the year of a Roth IRA conversion to “recharacterize” (i.e., undo) the prior year Roth IRA conversion. This is illustrated in the following example.

Example 1. On January 4, 2015, John converts all of his traditional IRA to a Roth IRA. In this case, John has until October 17, 2016, to recharacterize all or a portion of his 2015 conversion. That is, because October 15, 2011, falls on a Saturday, John has until the following Monday (October 17, 2016) to recharacterize his 2015 conversion.

Roth Conversion Timetable

The time requirements for making Roth IRA conversions and re-characterizations are listed in Table 1. Given this timetable, one is able to make a decision effectively early in 2015, wait to determine what effect the market may have on his or her Roth IRA and thereafter make a final decision more than nine months after the year in which the conversion took place. If you make the conversion and the value of the IRA assets declines, you can unwind the conversion. Thus, if set up properly, a taxpayer is afforded the opportunity to make a decision with “20/20 hindsight.”

TABLE 1

January 1, 2015 First date by which a 2015 Roth conversion may take place.
December 31, 2015 Last date by which a 2015 Roth conversion may take place.
April 15, 2016 Roth conversion taxes must be paid for 2015 conversion.
October 15, 2016 Recharacterization of 2015 conversion must take place no later than this date. Taxpayer can file for refund of taxes paid on Roth conversion.

 

Although recharacterizations were primarily used in the past to undo Roth IRA conversions because a taxpayer failed to meet certain qualifications (such as the $100,000 MAGI limitation), recharacterizations are now being used as a strategy to enhance the effectiveness of Roth IRA conversions. This is incredibly important to taxpayers in that recharacterizations allow taxpayers the benefit of hindsight. Furthermore, recharacterizations protect taxpayers from paying income tax on assets that no longer exist (in the case where the value of the Roth IRA declines from the time of conversion). These benefits are explained in the following examples.

Example 2. During 2015, Lisa converted all of her traditional IRA to a Roth IRA. At the time of conversion, Lisa’s traditional IRA was worth $100,000. On October 10, 2016, the Roth IRA was worth $130,000. As a result, Lisa chose to keep her 2015 conversion because the account increased 30 percent since the time of conversion, sheltering $30,000 of income from future income tax.

Example 3. Same facts as the previous example, except that the value of the Roth IRA declined to $75,000 as of October 10, 2016. In this situation, Lisa chose to recharacterize her 2015 conversion because the account had declined in value from the original conversion amount.

In both cases above, the choice to keep the Roth IRA conversion or recharacterize was fairly straightforward. In the first example, the Roth IRA had increased by 30 percent. Thus, if Lisa paid $25,000 on the $100,000 conversion, the “true” effective income tax rate on the conversion would be only 19.2 percent (i.e., $25,000/$130,000), as opposed to an effective income tax rate of 25 percent if the original conversion amount was used. In the second example, the decision was even easier to make in that the Roth IRA had gone down in value. In this case, Lisa chose to recharacterize her 2010 conversion in that she would not want to pay income tax on $25,000 of income that no longer exists.

Now, then, what would Lisa’s decision have been if the investment return within the Roth IRA had been something less than 30 percent, but greater than the original conversion amount? The answer to this question is far more complex and would necessitate further quantitative analyses to determine the overall income tax/economic effectiveness of the conversion (which is beyond the scope of this column). Regardless of the final decision made Lisa’s initial decision to convert $100,000 to a Roth IRA is of relatively low risk to her in that she has the benefit of hindsight through recharacterization.

Anti-Cherry Picking Rule

A taxpayer who makes a Roth conversion always may eliminate all tax liability associated with a Roth conversion by re-characterizing the entire Roth IRA. If some of the assets had increased in value and others had decreased, however, it would be more favorable to re-characterize only with respect to the loss assets and leave the assets that had increased in value in the Roth IRA. Unfortunately, the IRS anticipated this strategy in Notice 2000-39, which laid down what is generally referred to as the “anti-cherry picking rule.” These rules were designed specifically to prevent a taxpayer who performed a Roth conversion from thereafter re-characterizing only those stocks that declined in value. The effect of the rules is to prorate all gains and losses to the entire Roth IRA, regardless of the actual stock or fund re-characterized.

Example 1. On January 2, 2015, when John Doe’s IRA was worth $500,000, he converted the entire amount to a Roth IRA. John will owe ordinary income tax on the entire $500,000. The IRA consisted of 50-percent ABC fund ($250,000) and 50-percent XYZ fund ($250,000). As of April 15, 2015, the ABC fund had declined in value to $125,000, while the XYZ fund had increased in value to $275,000. Thus, the total value of the IRA account declined in value to $400,000. John would like to re-characterize the entire ABC fund but none of the XYZ Fund. Changes in the IRA are summarized in Table 2.

TABLE 2

Initial Value on Date of Conversion

Value on Date of Recharacterization

Relative Percentages of Overall Roth IRA on Date of Recharacterization

Increase/Decrease in Value

ABC Fund

$250,000

$125,000

31.25%

($125,000)

XYZ Fund

$250,000

$275,000

68.75%

$25,000

Total

$500,000

$400,000

100%

($100,000)

Without the anti-cherry picking rules, John could reconvert only those assets that dropped in value (the ABC fund) and eliminate $250,000 of tax liability (the value of the ABC fund on the conversion date). However, these rules require that the gains and losses of the entire IRA be applied on a pro rata basis for tax purposes. The first step is to calculate the value of the ABC fund as a percentage of the total value of the IRA as of the recharacterization date. This percentage is 31.25 ($125,000 / $400,000). Then the value of the IRA as of the date of conversion is multiplied by this 31.25-percent figure. Thus, if John were to re-characterize the ABC fund, he could reduce his taxable income by only $156,250 (.3125 x $500,000). This would result in John recognizing ordinary income attributable to the Roth conversion in an amount of $343,750 ($500,000 – $156,250), despite the fact that John’s Roth IRA is only worth $275,000.

Avoiding the Anti-Cherry Picking Rule

The anti-cherry picking rules can be avoided by specifically identifying assets to be transferred to newly established Roth IRAs, one Roth IRA for each grouping of assets. Typically, the grouping of assets would be a particular fund, particular stock or particular grouping of stocks within a market sector. Returns for different stocks, funds or market sectors could vary significantly. Some may decrease in value and others increase. Thus, if the investment performance of one Roth account is poor, a taxpayer may re-characterize this segregated Roth IRA back to a traditional IRA to eliminate the ordinary income associated with that conversion, while allowing the other Roth IRAs to remain unchanged. The idea is that you would put different types of investments (e.g., consumer goods, energy, communications, transportation, etc.) in segregated IRAs, convert each segregated IRA to a Roth IRA and thereafter recharacterize only those Roth IRAs that under-performed.

Example 2. Assume the same facts as in Example 1, but instead of creating a single Roth IRA, John decides to create separate Roth IRAs, one with the ABC fund and a second IRA with the XYZ fund. In this case, John would re-characterize the first IRA with the ABC fund. Because John recharacterized the entire IRA holding the first IRA, he will owe no income tax on the first IRA. Rather, John will only recognize ordinary income on the second IRA, in the amount of $250,000.

The steps involved in using the Roth segregation conversion strategy are summarized below:

  1. Identify separate holdings and convert separate holdings to Roth IRAs. In our example above, this would mean putting all the ABC Fund in IRA 1 and all the XYZ Fund in IRA 2.
  2. Pay tax on the Roth conversion. Income tax would be paid on the combined $500,000 of value.
  3. Re-characterize the specific Roth account. Roth IRA 1 would be reconverted to a traditional IRA, but IRA 2 would not.
  4. File an amended return for taxes paid on the Roth conversion. The reduction in tax payable would be $250,000.
  5. In most cases, the taxpayer will want to reconvert the re-characterized IRA back to a Roth to take advantage of the current low value of the assets.

Let us compare the result of these two examples (see Table 3). By segregating the IRA into two separate Roth IRAs, under the above facts, John is able to save over $26,000 in tax!

TABLE 3

Example 1

Example 2

Difference

Value on Date of Conversion

$500,000

$500,000

Value of Roth IRA after recharacterization

$275,000

$275,000

Value of Traditional IRA after recharacterization

$125,000

$125,000

Ordinary Income Recognized

$343,750

$250,000

($93,750)

Ordinary Income Tax @28%

$96,250

$70,000

($26,250)

In designing the separate Roth IRA accounts, the taxpayer might invest the assets of one account in technology fund/stocks, another in communications fund/stocks and another in transportation fund/stocks, etc. Because the anti-cherry picking rules apply only to investments within the same account, this strategy avoids the pro rata application of gains and losses to the re-characterized amount.

The key is to transfer assets expected to produce different returns into different IRAs (i.e., stocks with low price interdependence). Assets with high positive correlation coefficients would be placed in the same IRA. Assets with low positive or negative correlation coefficients would be segregated out into other IRAs. This would give the taxpayer the best chance of segregating the gain assets from the loss assets.

By using this strategy, a taxpayer could lock in the potential for future growth, while simultaneously hedging against market sector fluctuation. In many cases, this strategy poses little downside risk, with a tremendous upside potential.


ROBERT KEEBLER’S ROTH IRA CONVERSION DECISION CHART—Updated for 2015!

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ABOUT THE AUTHOR

robert-keebler-authorRobert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA is a partner with Keebler & Associates, LLP and is a 2007 recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels. He has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States and one of the Top 40 Tax Advisors to Know During a Recession. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and in estate, gift and income tax examinations and appeals.

In the past 20 years, he has received over 150 favorable private letter rulings including several key rulings of “first impression.” Mr. Keebler is nationally recognized as an expert in estate and retirement planning and works collaboratively with other experts on academic reviews and papers, and client matters. Mr. Keebler is the author of over 75 articles and columns and editor, author, or co-author of many books and treatises on wealth transfer and taxation, including the Warren, Gorham & Lamont of RIA treatise Esperti, Peterson and Keebler/Irrevocable Trusts: Analysis with Forms.

He is a frequent speaker for legal, accounting, insurance and financial planning groups throughout the United States at seminars and conferences on advanced IRA distribution strategies, estate planning and trust administration topics including the AICPA’s Advanced Estate Planning, Personal Financial Planning Conference and Tax Strategies for the High Income Individual Conference.

To contact Mr. Keebler, call his office at 920-593-1701 or by e-mail at robert. [email protected].


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