Most investors are well aware of the widely known perks offered by the Roth Individual Retirement Account (IRA): Qualified withdrawals after age 59 1/2 are tax free, the absence of required minimum distributions provides flexibility on how and when you tap the account, and those who inherit a Roth IRA can enjoy tax-free income from it.
But one lesser-known feature of the Roth IRA is among its most intriguing: Should the market fall significantly after you’ve converted a traditional IRA or 401(k) plan account to a Roth IRA – or if you’ve simply changed your mind – you have the right, within a given time period, to undo the transaction without tax repercussions.
That reversal, known as a recharacterization, offers an escape hatch should conditions shift enough that the original conversion no longer makes sense.
“There are very few times in life where you can take advantage of 20/20 hindsight,” says Mary Ann Sisco, senior vice president and director of client solutions in Northern Trust’s Personal Financial Services group. “This is one of them. So, depending on the timing, an individual can undo a Roth IRA conversion, and it’s as if the conversion never happened in the first place.”
An Option
for All Since 2010
For the first 12 years after the Roth IRA was
created with the Taxpayer Relief Act of 1997, only individuals who
made $100,000 or less could convert traditional IRAs and other
retirement accounts into new Roth accounts. The conversion required
only payment of taxes on the converted amounts, since Roth IRAs are
funded with after-tax contributions.
In 2010, revised conversion rules abolished the income threshold, allowing any individual to convert existing retirement account assets into Roth IRA accounts. However, rules allowing for recharacterizations remained untouched. So if the market nosedives after the conversion and triggers a tax bill due on funds that no longer exist, the individual can erase the conversion and keep the money originally earmarked for the tax bill.
Here’s how the process could look:
1. An individual in the 35% tax bracket converts $500,000 from a traditional IRA to a Roth IRA in early 2012.
2. The $500,000 is added to the individual’s adjusted gross income for 2012, resulting in an extra tax liability of $175,000.
3. If the assets grow following the conversion, the tax bill on the conversion remains the same.
4. If the assets lose value significantly after the conversion, the individual has the option to recharacterize the Roth IRA back into a traditional IRA. For example, if the value of the assets drops from $500,000 to $450,000, the individual still would face a $175,000 tax payment, representing a 38.9% rate, on the original $500,000 deposited into the Roth IRA. In this case, the owner might opt instead to undo the original conversion.
5. The recharacterization may be completed as late as October 15, 2013, if the tax filing is extended beyond the standard April 15, 2013 due date.
“Of course, you always have to run the numbers, but recharacterization offers some true flexibility,” says Garrett Buchanan, a financial consultant in the Financial Consulting Group at Northern Trust.
The Tax
Rub
Any discussion around Roth IRA conversions and
recharacterizations hinges on taxes – the
implications for future tax liabilities versus the current
year’s tax bill.
A Roth IRA conversion front-loads the taxes due, but there are other considerations to weigh. An individual should make a conversion only if he or she can pay the resulting tax bill out of taxable accounts while leaving enough to live on, Buchanan says.
Christopher Hoyt, a professor of law at the University of Missouri (Kansas City) School of Law, suggests that anyone contemplating a Roth IRA conversion in 2012 should adjust his or her quarterly estimated tax payments for the extra income generated by the conversion. So as long as payments essentially are equal over the course of the year and represent 110% of the previous year’s total tax amount, the Internal Revenue Service (IRS) won’t frown upon a tax bill that ends up being higher.
Conversely, if all estimates and withholding fall short of the 110% amount or are achieved via a large final estimated payment, and the conversion adds significantly to the taxable income, the IRS will assess a penalty.
Buchanan and Sisco say that individuals frequently simply balk at writing a large check to the IRS. Yet both suggest approaches such as making large charitable gifts – to a donor advised fund or otherwise – or recognizing large net operating losses for a business to soothe the perceived pain of moving assets into a Roth IRA. Both methods offset the higher income resulting from the Roth IRA conversion.
What to
Do?
Roth IRA conversion decisions fall into two camps:
tactical and strategic. Tactical converters, Buchanan says,
generally are responding to a specific situation, such as a lower
income year or a diagnosis of a terminal illness shortly after
retirement.
“There’s something about right now that says there’s an opportunity now or risk in the future that makes you believe some level of conversion will help in the long run,” he says.
Strategic conversions, alternatively, are rooted in comprehensive planning and forecasting. The typical candidate for strategic conversions, according to Buchanan, believes taxes will rise in the future, doesn’t expect to need the income during retirement and wishes to position his or her estate now to make it easier for the heirs once the estate passes to them.
“The strategic approach does take a leap of faith for many, as it’s requiring them to anticipate the unknown and not simply act on what they know,” he says.
Recharacterizations can bolster the strategic impact. For example, Sisco suggests individuals create separate Roth IRA accounts for different types of assets – perhaps one with company stock, one with international investments and a third with other U.S. stock holdings. If done in January 2012, an individual has about 20 months – a recharacterization request should be made by September 2013 – to determine which conversions make sense and which should be switched back to traditional IRA. So if the company stock soared, the other stock holdings posted decent gains and the international investments slumped, leave the stock Roth IRAs alone and recharacterize the international account.
Timing, however, remains the question, as there’s no simple rule of thumb to calculate if or when the do-over should occur.
“It comes down to how much the account has really gone down,” Sisco says. “You have to weigh other costs, such as accountant fees, costs from any legal advice and fees your custodian could charge.”
In addition, if you’re older than 70 1/2 years, the recharacterization to a traditional IRA will lead to a revised required minimum distribution (RMD) and a greater tax bill on that withdrawal.
You can, however, redo the do-over. If you complete a recharacterization in the year following the conversion (for example, the first nine months of 2013 on a 2012 conversion), you’re free to do another Roth IRA conversion 30 days later. Sisco cautions, however, that there is a risk that the account could recover its value in the time between recharacterization and the date when you re-convert. It can be as dizzying as it can be worth it.
“You’re moving income from a taxable status to an account that offers tax-free income for your entire retirement,” Hoyt says. “And with the option to undo the Roth IRA conversion with a recharacterization any time before the due date of your tax return, it’s set up so you should win.”
