Avoiding Roth recharacterization traps

The Roth recharacterization provides one of the few second chances in the tax code. In essence, it’s a do-over. The provision allows you to undo, or reverse, a Roth conversion, effectively treating the move as if it never happened. Any tax paid on the conversion is refunded. However, there is a time limit — anyone who converts to a Roth individual retirement account has until Oct. 15 of the year after the conversion to recharacterize it.

Recharacterization must be done as a trustee-to-trustee transfer and the funds must go back to a traditional IRA, even if the conversion was from a company plan. Partial recharacterizations are permitted. Below are a few Roth recharacterization traps you might face before the October deadline.

Ineligible conversions. Two key restrictions remained in 2009: Clients were ineligible to convert to a Roth IRA if they had either modified adjusted gross income (MAGI) of over $100,000, or if they were married but filing separately. Oct. 15 represents the last recharacterization opportunity for someone forced to recharacterize because they did not qualify for a Roth conversion due to income limits or filing status.

For example, Byron, 45, and his wife had earnings of $90,000 and filed a joint return, putting them comfortably under the $100,000 MAGI limit. Believing that they would qualify, Byron converted his $200,000 IRA to a Roth last summer. On Dec. 22, however, Byron’s boss surprised him with a $15,000 bonus. This pushed the couple’s income above the MAGI limit by $5,000.

If you find that one of your clients, like Byron, converted in 2009 but was not eligible to do so, it’s not too late to fix the mistake.

If an ineligible conversion is not recharacterized in time, clients will be faced with an assortment of harsh tax consequences. First, the amount “converted” will be considered distributed from the traditional IRA. That means the full amount will be subject to ordinary income tax — plus a 10% penalty if your client is under 591/2. If the funds were eligible to be converted, they would have been taxed anyway, so the tax is paid either way. Plus, although the funds may still be held in the Roth IRA account, they are not technically Roth IRA funds and won’t receive favorable tax treatment.

But wait, the damage doesn’t stop there. Any amount contributed (wrongly converted) to the Roth IRA above the eligible total will be considered an excess contribution. It will be subject to an additional 6% excise tax for each year it remains in the Roth IRA account.

Use of funds for tax purposes. Although the value of a Roth conversion is greatly diminished if money from an IRA is used to pay the tax, some individuals still choose to do that, even if it leads directly to less money being available for recharacterizations.

For example, Don has $200,000 in an IRA and no other money. He withdraws $50,000 from his IRA to use for taxes and converts the remaining $150,000 to a Roth IRA. Don owes taxes on the full $200,000 withdrawal from his traditional IRA, even though only $150,000 was converted. In addition, Don is under 591/2, so he also owes the 10% early withdrawal penalty on the $50,000 not converted.

Now suppose Don’s Roth account value drops to $120,000 and he would like to recharacterize. He thinks he should be able to put the full $170,000 (Roth balance + taxes paid) back into the traditional IRA. But Don is limited to moving only $120,000 back to his traditional IRA. In addition, he will still owe taxes on the $50,000 distribution he used to pay the tax.

The same result would happen if all the money is converted to a Roth IRA and Roth funds are withdrawn to pay for the conversion taxes. For example, Nate converted $100,000 to a Roth IRA in 2009. In April of 2010 he withdrew $20,000 to pay for the conversion taxes. In July, Nate’s account value dropped significantly. Here, even though all of Nate’s IRA had been converted to a Roth, the full value of a recharacterization will not be realized because it didn’t all stay in the account. In addition, Nate is under age 591/2, so the 10% penalty will apply to the funds withdrawn to pay the taxes.

Identify all clients who did 2009 conversions and take a few minutes to double-check them. A little bit of your time before the Oct. 15 deadline could save clients a lot of money and headaches later.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.