In a recent article, I briefly covered the topic of Recharacterization. The example that I gave was pretty simplistic – you converted an amount, and decided later to recharacterize that amount back to an IRA. What if it gets complicateder?
There are some steps you can take in your conversion that will help you to recharacterize later, if the occasion should arise. These steps to structure the conversion are by no means required, they’d fit into a “simplifying your life” category, more than anything – or what I have heard referred to as a CYA* activity.
Structuring a Conversion
If you think you’ll want to come back and consider recharacterizing some of your conversion, you should start off with a brand-new Roth IRA account as the receiver of the conversion. This way you don’t have to worry about separating the money later on during the recharacterization (if that comes about).
In addition, depending upon the volatility of your holdings, you might want to chunk things up even further – especially if we’re dealing with a sizeable amount of money. You might consider chunking your account into Large-caps, small-caps, and global stocks, at the very least. There’s no limit on the number of funds you could split the holdings into, so if you wanted, you could open a new Roth account for each asset that you own.
The point to all of this splitting is that, in the event that one of the assets dramatically reduces in value through the year, since you’ve kept them segregated, it will be simple to recharacterize just that one asset. This way you can keep from paying higher tax on a dramatically reduced asset.
But wait! Doesn’t the IRS treat all IRAs as one account? Hold on, there – before you get all dressed up and jump off a chair: You’re making the assumption that there is consistency in the rules… and consistency in the rules would be a huge departure from the IRS’ proud, nearly 150-year track record. Besides, if the rules were consistent and made sense, then what would guys like me write about?
In the case of recharacterizing funds converted to a Roth IRA, the IRS only considers the account you converted into. This is why it’s important to (at the very least) start with a fresh new account – because any recharacterization in an account that included prior conversions and/or contributions will likely dilute the effect of the recharacterization. At the very least, commingling conversion funds will really complicate things, and lead to some potentially uncomfortable moments during the audit.
The more you’ve chunked your account, the easier it will be to choose only those funds that have fallen in value to recharacterize. Otherwise the benefit is diluted by any increases on other holdings.
* Not really sure, but I think CYA in this sense stands for “Chunk Your Accounts”. You may have a different interpretation.
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I can learn from you, you can learn from me - please leave your comments and links!Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry. . Read more from this author
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Jim,
When I read the IRS pub 509, it seems to me that you have to recharacterize the amount converted plus earnings (positive or negative). So if I convert $50k to a Roth and it loses $2k, if I recharacterize the full amount, I can only recharacterize $48k, and I’ll owe tax on the remaining $2k, though I’ll have nothing to show for it.
“Recharacterizations
You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called recharacterizing the contribution.
To recharacterize a contribution, you generally must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for your tax return for the year during which the contribution was made, you can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA. If you recharacterize your contribution, you must do all three of the following.
* Include in the transfer any net income allocable to the contribution. If there was a loss, the net income you must transfer may be a negative amount….”
Hi, Helen -
This can be pretty confusing… If the funds were in a trad IRA and you converted to a Roth but then recharacterized, as long as you segregated the amount that was to be recharacterized in a separate account, whatever the amount that is in the account is the amount that you transfer back to the trad IRA.
In your example, converting $50,000 to the Roth, then losing $2k, you could transfer the remaining $48,000 back to the trad, recharacterizing it along the way. File form 8606 to account for the differential. As long as you’ve kept everything separated and have done trustee-to-trustee transfers, no tax is owed on this series of transactions. The net income is included if you’ve had a loss – that is, instead of $50k being transferred back, you’ve included the net income of ($2k), for a total recharacterization of $48k. The reverse would be true if it gained $2k, you’d just transfer back the $52k result (not that you would do this) – still no tax. This is because the recharacterization pretends that the conversion never happened, and you left the funds in the trad, with the resulting $2k loss occurring there.
Does that clear it up?
jb