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CCH Says Roth IRA Recharacterization May Be Latest Trend, As Tax Planning Assumptions Are Set on End

Deciding When to Convert and When to Recharacterize Requires Understanding Current and Future Financial Picture

(RIVERWOODS, ILL., January 2011) – If 2010 was the year of the Roth IRA conversion, 2011 may very well be the year of the Roth IRA recharacterization, thanks to 2010 year-end tax law changes, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com).

Prior to 2010, a taxpayer’s adjusted gross income (AGI) had to be $100,000 or less in order to be eligible to convert a traditional IRA to a Roth IRA. That restriction was lifted as of 2010, allowing any taxpayer regardless of income to convert funds from their traditional IRA to a Roth IRA. Also, taxpayers making a conversion in 2010 had the added option of being able to choose between paying all the income tax on the converted amount in 2010 or splitting the tax bill evenly over 2011 and 2012. The disadvantage of delaying payment of the taxes until 2011-2012 was that tax rates were expected to increase.

“Many taxpayers went into 2010 with a set of tax planning assumptions about future years that may have made them inclined to convert their traditional IRAs to Roth IRAs,” according to Nick Kaster, JD, CCH Senior Pension Law Analyst. “However, with the extension of the Bush-era tax cuts, those tax planning assumptions are no longer the case and more people may see tax advantages from either delaying payment of their taxes on a 2010 Roth IRA conversion until 2011-2012 or recharacterizing their Roth IRAs back to a traditional Roth IRA to further delay tax obligations.”

Traditional v. Roth IRAs

There are key differences between traditional and Roth IRAs as to the tax consequences of making contributions and taking distributions.

Depending on a taxpayer’s income and active participant status, contributions to traditional IRAs are deductible from income tax in the tax year in which the contribution is made. However, distributions are taxed as ordinary income.

Contributions to Roth IRAs, on the other hand, are made after-tax and are therefore nondeductible. However, “qualified” distributions are taken free of tax.

As a result, if people believe they’ll be in a higher tax bracket in retirement, they can use a Roth IRA to pay taxes now rather than in retirement. Also unlike traditional IRAs that require people take required minimum distributions (RMDs) starting at age 70½, Roth IRAs do not have RMDs, allowing people to pass the proceeds onto their heirs.

Deciding on if or when to recharacterize a Roth IRA requires weighing several factors. Below, CCH answers questions to consider before making a change.

1. How long do taxpayers have to recharacterize a Roth IRA conversion?

Taxpayers who convert traditional IRAs to Roth IRAs can change their mind and undo a conversion by “recharacterizing” the contribution back to a traditional IRA in a given tax year. The recharacterization must be completed by the last date, including extensions, to file or re-file prior-year taxes. This is generally on October 15. However, for the 2010 tax year, it is October 17, 2011 as October 15 is a Saturday.

2. When should someone consider recharacterizing a Roth IRA conversion?

There are several reasons someone may want to recharacterize a Roth IRA. These include:

• The value of the investment in the Roth IRA has declined since the conversion took place;
• The taxpayer’s income in the year of the conversion was higher than expected or the additional income from a Roth IRA conversion pushed the taxpayer into a higher income tax bracket than anticipated;
• The taxpayer does not have the cash needed to pay taxes on the conversion; or
• The taxpayer now believes their taxable income in retirement will be less than previously anticipated, offsetting the advantages of a Roth IRA’s tax-free distributions.

For the 2010 tax year, recharacterization also is useful to help minimize near-term taxes. One of the premises of Roth IRAs is that some taxpayers may want to pay taxes in the near-term if they think they will be in a higher tax bracket during their retirement years. However, the urgency to make a conversion in 2010 for some taxpayers was because income tax rates were expected to increase starting in 2011. As this is no longer the case – at least through 2012 – some taxpayers may benefit from recharacterizing their Roth IRA and waiting until 2012 to reassess their situation and decide then if a re-conversion makes sense. This would allow them to delay their tax obligations for a few additional years.

3. How is a Roth IRA recharacterization done?

In order to recharacterize a Roth IRA, the taxpayer must notify the trustee of the Roth IRA and the trustee of the traditional IRA and complete the necessary paperwork to execute the recharacterization.

4. How is a recharacterization reported for tax purposes?

For federal income tax purposes, a recharacterized contribution is treated as having been contributed to the traditional IRA (the second IRA in IRS terms) on the same date and for the same taxable year that the contribution was initially made to the Roth IRA (the first IRA). The taxpayer is responsible for accounting for all recharacterization activity when reporting non-deductible IRA contributions on IRS Form 8606, or as required by the IRS.

Additionally, if the Roth IRA had a net income profit or losses prior to recharacterization, this also needs to be accounted for in reporting 2010 income to the IRS. IRS Publication 590 includes a worksheet for determining the net income attributable to a recharacterization.

5. Can taxpayers subsequently convert their traditional IRA to a Roth IRA again?

Yes. However, they have to wait until the next tax year before making a “re-conversion” back to a Roth IRA. In addition, at year-end, a 31-day period must pass between recharacterization and re-conversion, meaning someone can’t make one move on December 31 and an opposite one on January 1.

6. What are the benefits of doing a Roth IRA conversion?

Despite the flux in the tax code, the primary benefits of Roth IRA conversions remain the same:

• Unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions (RMDs) starting at age 70½. This allows funds to continue to accumulate if they are not needed for living expenses during retirement.
• Because no RMDs are required during the account owner’s life, a Roth IRA is an effective vehicle to pass on wealth to the next generation.

If achieving these benefits is important, then taxpayers who made a conversion in 2010 and were in a lower than anticipated tax bracket may benefit in staying with their Roth IRA, particularly if their income is expected to increase in the next several years. Rather than paying all the taxes on the conversion in 2010, however, they may want to consider splitting their tax bill over 2011-2012, assuming their taxable income is not expected to push them into a higher tax bracket.

The election to report the taxes in 2010 or to split the taxes between the 2011 and 2012 tax years is made on the 2010 Form 8606.

7. When is staying with a traditional IRA or 401(k) better than converting to a Roth IRA?

Individuals who think they will be in a lower tax bracket in retirement, individuals who only have a few years before retirement and plan to take distributions from their Roth IRAs during retirement, and people who cannot afford to pay the near-term taxes on a Roth IRA conversion may not realize many benefits by converting to a Roth IRA.

“The federal tax code for the next couple of years is now clearer. However, people’s personal situations can be fluid,” said Kaster. “As a result, taxpayers considering a Roth IRA conversion or recharacterization would benefit from speaking with their tax advisors about the tax benefits and consequences specific to them.”

About CCH, a Wolters Kluwer business  

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).

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