A deadline for recharacterizing contributions is fast approaching, so advisors need to help their clients decide now whether taking that step is a good idea
Last year — 2010 — was the first year tax-deferred individual retirement accounts could be converted into tax-free Roth IRAs without having to worry about exceeding adjusted gross income (AGI) limits. Those who made the leap from a traditional IRA to a Roth IRA were betting that paying the tax now would be a small price to pay for tax-free returns and tax-free distributions of those returns for themselves and for their heirs, for many years into the future. They could also make regular Roth IRA contributions of after-tax dollars if they didn't exceed AGI limits. But these are difficult times. No doubt some Roth IRA investments went south instead of north, causing the luster to dull. Disenchantment can descend to murderous intent. Conversely, those who made regular IRA contributions may have seen their investments do well and are now wishing they had contributed to a Roth IRA instead. What's a taxpayer to do?
Help is near. Your clients have until Oct. 17, 2011 to “recharacterize” contributions to Roth IRAs as contributions to traditional IRAs or vice versa. This will transform a contribution that was made to one type of IRA (Roth or traditional) into a contribution to the other type, effective as of the date of the original contribution. A recharacterization is a direct trustee-to-trustee transfer — and only a trustee-to-trustee transfer will work — from one type of IRA to another. Amounts recharacterized must be accompanied by income attributable to the contribution, from the date of contribution through the date of recharacterization.
For tax purposes, the Internal Revenue Service treats the recharacterized amount as if the taxpayer had contributed it to the other type of IRA in the first place. And the IRS treats income related to the recharacterized amount as though the taxpayer earned it in the other type of IRA.1
Because of recharacterization, a Roth IRA conversion contribution is a tax bet that can be hedged. By recharacterizing that contribution, your client can get a refund of income taxes he paid on the Roth IRA conversion. The same goes for a regular Roth IRA contribution: Your client can recharacterize it into a traditional IRA, which will qualify for the IRA income tax deduction, subject to regular IRA contribution deduction limitations. Conversely, anyone who made a traditional IRA regular or rollover contribution can recharacterize it as a Roth IRA contribution, an attractive move if the traditional IRA investments have performed well thus far.
Even better, a failed IRA contribution (that is, a contribution that the taxpayer tried to make but was invalid for some reason) to one type of IRA, such as to a Roth IRA, may be recharacterized to another type of IRA, such as a traditional IRA, provided that the contribution to the other type of IRA would have been permissible. For example, exceeding Roth IRA AGI contribution limits can invalidate a Roth IRA contribution, but exceeding AGI limits that apply to regular IRA contributions means that the contribution is still valid but won't qualify for an income tax deduction.
Stay the Course?
Just because the markets went down doesn't mean recharacterizing contributions to a Roth IRA as contributions to a traditional IRA is the right thing to do. Once those amounts have been recharacterized, they can't be quickly converted back to a Roth IRA. Your client must wait a certain amount of time before he can then recharacterize the traditional IRA contribution back to a Roth IRA (known as “reconversion”). He must wait until Dec. 31 of the year in which the Roth IRA conversion occurred, or at least 30 days after the recharacterization occurs, whichever is later.
Markets can move significantly in 30 days, to say nothing of several months. A major market upturn could occur while the IRA isn't a Roth IRA. If so, tax-free investment returns will be missed early in the life of the Roth IRA strategy, and the tax cost of reconversion will go up because the account value has grown. It may be better to take the long view, stay the course and avoid recharacterizing. Long-term financial planning and investment projections may help put the decision into perspective.
Nevertheless, many taxpayers will want to recharacterize. A limited amount of time remains to do so for 2010 conversions and contributions.
A taxpayer must indicate his election to recharacterize by the due date of his income tax return, including extensions of time to file, for the taxable year that includes the contribution to be recharacterized. For individuals and trusts reporting on the calendar year, the last possible date for recharacterizing a 2010 IRA or Roth IRA contribution is generally Oct. 17, 2011. The extra six months come courtesy of an automatic extension of time granted to all taxpayers, whenever the taxpayer has filed the tax return on time (including extensions).2 For taxpayers who didn't file on time (including filing after the date to which extensions were granted), that deadline was April 18, 2011. (See “Due Date Examples,” p. 53.)
But it's not a good idea to wait until the last possible minute, because it takes time for IRA providers to process recharacterizations. The better practice is to complete the recharacterization at least several weeks before the deadline, leaving enough time to fix problems if things don't go as planned.
Getting an Extension
If the taxpayer missed the recharacterization deadline but timely filed the tax return, he can consider applying for an extension of time to recharacterize under Treasury Regulations Section 301.9100-3. The IRS has issued many recharacterization extensions, mostly for taxpayers who unexpectedly discovered some time after the recharacterization deadline that a Roth IRA contribution failed because it exceeded the AGI limits. The IRS may also find other valid reasons to grant an extension. For example, it might grant an extension if the IRA custodian failed to properly process a recharacterization. To get an extension, the taxpayer applying for it must demonstrate to the IRS' satisfaction that he acted reasonably and in good faith and that granting relief won't prejudice the government's interests.3
Types of Contributions
In addition to being timely recharacterized, the contribution must be of a type that may be recharacterized. That includes any contribution to any “individual retirement plan.” But when a traditional IRA contribution is recharacterized as a Roth IRA contribution, recharacterization will be recognized only to the extent no deduction was allowed with respect to the contribution to the IRA before recharacterization.4
An “individual retirement plan”5 includes an IRA described in IRC Section 408(a) and an individual retirement annuity described in IRC Section 408(b).Both kinds are commonly referred to as “traditional IRAs.” A Roth IRA is also an “individual retirement plan” and thus may qualify for recharacterization of contributions because IRC Section 408A(a), authorizing Roth IRAs, provides that a Roth IRA is generally treated for IRC purposes in the same manner as an individual retirement plan. Education IRAs aren't “individual retirement plans” and so contributions to them can't be recharacterized.
That all seems straightforward, except that recharacterization regulations point out that not everything that goes into an IRA can be recharacterized.
What Can be Recharacterized
The following contributions may be recharacterized:
Regular contributions to Roth IRAs and Roth IRA conversion contributions.
Regular contributions to traditional IRAs. Although traditional IRA contributions might qualify for an income tax deduction and thus not qualify for recharacterization,6 the effect of recharacterization is to negate the income tax deduction, making recharacterization permissible.7 But if the taxpayer wrongly claims an income tax deduction for the regular IRA contribution in spite of recharacterizing that contribution to a Roth IRA, the attempted recharacterization fails. A regular IRA contribution that was unsuccessfully recharacterized as a Roth IRA contribution because an income tax deduction was claimed, is treated as having been made to the traditional IRA notwithstanding the recharacterization.8 But the IRS regulations don't say how to fix that. Presumably, the contribution plus earnings should be transferred back to the traditional IRA.
If regular contributions or Roth IRA conversion contributions have been transferred to another account of the same type in a direct, trustee-to-trustee transfer, a recharacterization of the initial contribution may nevertheless be made.9
Failed Roth IRA contributions to traditional IRAs. But, to qualify for recharacterization, the contribution to a traditional IRA must be permitted. Failed Roth IRA contributions include, for example, regular contributions barred by the AGI limits that result in excess contributions.10
The IRS hasn't specifically approved recharacterizing a traditional IRA rollover contribution that failed because a taxpayer violated the rule prohibiting more than one rollover of multiple distributions received in any 12-month period. Such a failed rollover is an excess contribution that should qualify for recharacterization, just as a failed Roth IRA contribution does, although the IRS so far hasn't specifically said so. And since the income tax must be paid on the failed rollover contribution in any event, recharacterization as a Roth IRA conversion offers the advantage of future tax-free returns and tax-free distributions, as well as avoidance of lifetime required minimum distributions (RMDs).
What Can't be Recharacterized
The following can't be recharacterized:
A tax-free rollover of a distribution from one traditional IRA to another. That's because a tax-free transfer may not be recharacterized. But the amount rolled over could become the subject of a Roth IRA conversion contribution other than by recharacterization.11
Employer contributions to Savings Incentive Match Plan for Employees (SIMPLE) IRAs or Simplified Employee Pension (SEP) IRAs (technically, IRC Section 401(k) plans), along with elective deferrals to another type of IRA. That's because these types of plan aren't individual retirement plans. But a taxpayer can recharacterize to reverse an impermissible rollover or transfer from a traditional IRA to a SIMPLE IRA.12
Regular contributions to employer-sponsored designated Roth accounts (DRACs) and contributions to in-plan Roth conversions to elective deferral accounts. Employer-sponsored plans aren't individual retirement plans.
Recharacterization of Income
It's not enough to recharacterize the amount of a contribution. The taxpayer must also recharacterize income related to the contribution.
If an entire IRA consists of only a single contribution, and no distributions have been made from that account, then recharacterizing the entire IRA automatically satisfies the requirement that income be transferred along with the contribution. For example, if an IRA holding ABC stock and XYZ stock was concurrently transferred in a 2010 Roth IRA conversion to two separate Roth IRAs, one holding ABC stock and the other holding XYZ stock, either one of the two accounts may be recharacterized without disturbing the other. This is highly useful if one stock's value grew even as the other's fell.
The amount of that income is determined under a formula prescribed by regulation.13 IRS Publication 590 offers a worksheet for this purpose.
If one of two or more accounts of the same type is being recharacterized, only the income from the account being recharacterized must accompany the recharacterization transfer.
If two or more contributions have been made to a single IRA in the same tax year, the taxpayer may choose which contribution on which date is being recharacterized.
Once the taxpayer has determined that he can make a recharacterization and the amount to transfer, the taxpayer must take two steps: (1) make an election, and (2) transfer the amount to be recharacterized in a trustee-to-trustee transfer.
The taxpayer makes the election by notifying the IRA provider of both the transferor IRA and the transferee IRA of the election, along with the recharacterization details (of course, they may be one and the same IRA provider). The taxpayer must complete both steps by the recharacterization due date.
IRA providers have forms for this purpose. The taxpayer should keep a copy for the taxpayer's records, and it's a good practice to have some evidence showing when the IRA providers received the forms. Even though there's a form, it's a good idea to make sure that the form conveys the following information to the IRA provider, as required in Treas. Regs. Section 1.408-5, Q&A-6(a):
The date on which the contribution was made to the transferor IRA and the tax year for which it was made;
A direction to the trustee of the transferor IRA to transfer, in a trustee-to-trustee transfer, the amount of the contribution and net income allocable to the contribution to the trustee of the transferee IRA; and
The name of the trustee of the transferor IRA and the trustee of the transferee IRA and any additional information needed to make the transfer.
The taxpayer should create and keep records evidencing the recharacterization with his permanent records relating to the retirement accounts affected by the recharacterization.
Recharacterization by Executor
An executor, administrator or other person responsible for filing the decedent's final federal income tax return can recharacterize a contribution made by the decedent during the decedent's final tax year.14 In making the decision whether to recharacterize, executors should consider the effect on the estate's beneficiaries if not all beneficiaries have identical interests in the IRA compared to other property of the decedent. For example, letting a Roth IRA conversion stand affects the Roth IRA beneficiaries favorably, but could have the effect of lowering the overall inheritance of other estate beneficiaries by the amount of the income taxes on the Roth IRA conversion. That can be a tough choice, and the answer may be to recharacterize less than all of the Roth IRA conversion.
The executor must also consider what effect recharacterization may have if recharacterizing means making a transfer to a new IRA, in which no beneficiary will have been named by the decedent. That could shift who gets what. And since the beneficiary that sets the number of years for making RMDs will be the beneficiary of the transferee IRA, the move could have a disastrous effect on the payout term.
There should be no taxable gift from making a recharacterization. Since the recharacterization is an election by the executor, no beneficiary of the estate has made a transfer. In addition, gift tax values are generally determined without regard to income taxes, consistent with ignoring income taxes in determining the estate tax value of IRAs.
- Treasury Regulations Section 1.408A-5, Q&A-3.
- Internal Revenue Service Publication 590, at p. 31. See also Internal Revenue Code Section 408A(d)(6) and (7); Treasury Regulations Section 301.9100-1 and 301.9100-2(b); and IRC Section 7503.
- See, for example, Private Letter Ruling 201024071 (March 25, 2010), in which the value of the Roth individual retirement account declined by half (reason for decline not stated in published ruling).
- IRC Section 408A(b)(6).
- The definition of “individual retirement plan” is found in IRC Section 7701(a)(37).
- IRC Section 408A(d)(6)(B)(ii).
- Treas. Regs. Section 1.408A-5, Q&A-3, last sentence.
- Treas. Regs. Section 1.408A-5, Q&A-10, Example 3.
- Treas. Regs. Section 1.408A-5, Q&A-7, and Q&A-10, Example 2.
- Treas. Regs. Section 1.408A-4, Q&A-3. While regular Roth IRA contributions aren't permitted in whole or in part if adjusted gross income limits are exceeded, traditional IRA contributions are so limited only as to the amount deductible; the non-deductible portion becomes an after-tax contribution giving rise to income tax basis in the account.
- Treas. Regs. Section 1.408A-5, Q&A-4 and Q&A-10, Example 4.
- Treas. Regs. Section 1.408A-5, Q&A-5.
- Treas. Regs. Section 1.408A-5, Q&A-2.
- Treas. Regs. Section 1.408A-5, Q&A-6(c).
Michael J. Jones is a partner in Monterey Calif.'s Thompson Jones LLP and chairs the Trusts & Estates Retirement Benefits Committee