To Our Clients:
Our last article spoke briefly on the opportunity to convert a Traditional IRA to a Roth IRA.
But what if the conversion proves to be a failing strategy (i.e…the account decreases in value from when you originally converted it.) How do you undo it? Do any strategies exist to maximize the results?
Following we will discuss tax and investment strategies that should be carefully coordinated prior to a Roth IRA conversion to insure the results are optimized.
Recharacterizations
Under the tax law, taxpayers are allowed to “recharacterize” (i.e, undo) a Roth IRA conversion which, in effect, eliminates the taxable income associated with the conversion because the funds are rolled back into a traditional IRA. A recharacterization can take place at any time during the tax year in which the conversion takes place, but can also take place in the year following the year of conversion, provided that the recharacterization is done on or before the due date of the income tax return (including extensions). Therefore, a taxpayer has the ability to undo a Roth IRA conversion as late as October 15th of the year following the year of conversion without having to pick up the conversion amount as taxable income.
For example, if a taxpayer converts $600,000 to a Roth IRA on January 1, 2010, he/she has until October 15, 2011 to determine if he/she wants to keep all (or any portion) of the $600,000 Roth IRA conversion. If the IRA has grown from $600,000 to $700,000, the taxpayer most likely will keep the Roth IRA conversion in that $100,000 of growth has been shifted into a tax-free environment. Alternatively, if the IRA has declined in value from $600,000 to $550,000, the taxpayer most likely will recharacterize all of the $600,000 conversion in order to eliminate paying income tax on $50,000 of value which no longer exists.
Keep in mind that the primary purpose of recharacterizing a Roth IRA conversion is to undo a conversion where the current value of the Roth IRA is less than the value at the time of conversion. In this case, by recharacterizing the conversion, no income tax on “phantom” income will have to be paid.
Roth IRA Segregation Conversion Strategy
Although recharacterizations can be quite effective, they are not completely efficient. As previously mentioned, if you choose to convert to a Roth IRA, you have the option to eliminate the income tax liability associated with the conversion by recharacterizing the entire amount. If some of the assets have increased in value while others have decreased since the time of conversion, however, it would be more favorable to recharacterize only those assets that have experienced a loss.
Unfortunately, the IRS anticipated this strategy and promulgated the “anti-cherry picking” rules. In particular, the anti-cherry picking rules were designed specifically to prevent taxpayers from recharacterizing only those Roth IRA assets that declined in value. The effect of these rules is to prorate all gains and losses over the entire Roth IRA instead of on an asset-by-asset basis, regardless of the specific asset recharacterized.
Notwithstanding the above, the “anti-cherry picking” rules can generally 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, stock or 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. Consequently, if the investment performance of one Roth IRA investment is poor, you 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 goal is to put different types of investments (e.g., consumer goods, energy, communications, transportation, etc.) into “segregated” IRAs, convert each segregated IRA to a Roth IRA and, thereafter, re-characterize only those Roth IRAs that under-performed.
Below is a diagram explaining this strategy:
Roth IRA Segregation Conversion Strategy
If you are interested in learning more about Roth IRA conversions, tax and investment planning strategies, please call your Sheehan Service Partner to arrange an appointment.