Roth re-characterization confusion

Recent market volatility exposed a basic misunderstanding by financial advisers and even certified public accountants of the mechanics of undoing Roth conversions, a process called a Roth re-characterization.

You will need to know how this works if clients or their accountants ask you about it.

Here are some Roth re-characterization facts:

• A Roth conversion can be re-characterized for any reason.

• A partial re-characterization can be done.

• A Roth re-characterization is the process of undoing all or a part of a Roth conversion and eliminating the income tax that would have been owed on the amount that was re-characterized.

• A Roth re-characterization is treated as if the funds never left the traditional individual retirement account.

• Roth IRA conversions may generally be re-characterized up to Oct. 15 of the year following the year that the conversion was made. The date is Oct. 17, 2011, for re-characterizations of 2010 Roth conversions (Oct. 15 is a Saturday).

• A Roth re-characterization can be done only as a direct transfer of the funds from the Roth IRA back to a traditional IRA, not a withdrawal from the Roth IRA and a subsequent deposit to a traditional IRA. The funds go back to a traditional IRA even if the funds were originally converted from a company plan.

• The re-characterized funds can be transferred to the same IRA or a different one.

• If the tax return for the year of the Roth conversion already has been filed, a re-characterization can still be done by the Oct. 15 due date. It would be reported on an amended tax return, and the tax liability on the conversion would be eliminated.

• No one who did a 2010 Roth conversion will be forced to re-characterize, because the Roth conversion eligibility requirements were permanently repealed for 2010 and later years.

Roth re-characterization confusion seems to be related to a failure to understand that every Roth re-characterization involves two, often very different, amounts: the re-characterized amount and the transfer amount.

The re-characterized amount is the amount of Roth conversion income that will be removed from income.

For example, if you converted $100,000 to a Roth IRA, you have $100,000 of income to report (assuming all the converted funds were pre-tax). If you re-characterize the entire $100,000 conversion, you will reduce taxable income by the same $100,000, meaning that all the conversion income is removed from income.

The transfer amount is the amount of Roth funds that have to be transferred back to a traditional IRA in order to complete the re-characterization.

For example, let’s say Phil converted $100,000 to a new Roth IRA. No other additions or subtractions to the account were made, and his balance has dropped to $60,000.

Obviously, Phil should re-characterize his conversion if he doesn’t want to end up paying tax on lost value. Because Phil will make a full re-characterization, the entire $60,000 will be moved back to a traditional IRA as the net amount of his $100,000 conversion.

If Phil seeks to re-characterize only $60,000, he will still owe tax on $40,000. Instead, a full re-characterization is made by using the full value of the original conversion, which, in this case, was $100,000.

Phil re-characterizes the full $100,000, and his entire tax on the Roth conversion is eliminated. But the actual amount of funds transferred back to his IRA is only the $60,000 — what is left of 100% of his converted funds.

A CPA with whom I spoke had a similar case and couldn’t understand how you can remove $100,000 from income by moving only $60,000. He just couldn’t grasp that the $60,000 of value that was still in the Roth account represented the full $100,000 that was originally converted.

He thought that the only amount that can reduce income was the amount transferred back to the traditional IRA, because he confused the two amounts. In fact, the whole point of a Roth re-characterization is undoing the Roth conversion.

The more the value of the Roth falls, the bigger the tax benefit from re-characterizing. Being aware of just how a re-characterization works can help you be a resource to your clients, in even the most volatile markets.

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