How Do I … Convert a Traditional IRA to a Roth IRA?

People are buzzing about Roth Individual Retirement Accounts (IRAs). Unlike traditional IRAs, “qualified” distributions from a Roth IRA are tax-free, provided they are held for five years and are made after age 59 1/2, death or disability. You can establish a Roth IRA just as you would a traditional IRA. You can also convert assets in a traditional IRA to a Roth IRA.

Before 2010, only taxpayers with adjusted gross income of $100,000 or less were eligible to convert their traditional IRA (provided they were not married taxpayers filing separate returns). Beginning in 2010, anyone can convert a traditional IRA to a Roth IRA, regardless of income level or filing status.

Comment: While you can only contribute a maximum of $5,000 to a Roth IRA for 2010 (plus a $1,000 catch-up contribution if you are over age 50), you can convert an unlimited amount from a traditional IRA.

Conversion is treated as a taxable distribution of assets from the traditional IRA to the IRA holder, although it is not subject to the 10 percent tax on early distributions. While paying taxes on conversion is undesirable, the advantages of holding assets in a Roth IRA usually outweigh this disadvantage, especially if you will not be retiring soon. Furthermore, if you convert assets in 2010, you have the option of including them in income in 2011 and 2012 (50 percent each year) instead of 2010.

Comment: Generally, this income-splitting would be advantageous to any taxpayer who does not expect a sharp increase in income in 2011 or 2012. A wildcard factor is that the lower income tax rates that have been in effect since 2001 will expire after 2010 and could increase in 2011.

There are four ways to convert a traditional IRA to a Roth IRA:

• A rollover - you receive a distribution from a traditional IRA and roll it over to a Roth IRA within 60 days;
• Trustee-to-trustee transfer - you direct the trustee of the traditional IRA to transfer an amount to the trustee of a Roth IRA;
• Same-trustee transfer - the trustee of the traditional IRA transfers assets to a Roth IRA maintained by the same trustee; or
• Redesignation - you designate a traditional IRA as a Roth IRA, instead of opening a new Roth account.

Comment: The account holder does not have to convert all of the assets in the traditional IRA.

Another advantage of converting assets from a traditional IRA to a Roth IRA is that you can change your mind and put the assets back into the traditional IRA. This is known as a recharacterization. You have until the due date, with extensions, for the return filed for the year of conversion. Thus, if you convert assets in 2010, you have until mid-October in 2011 to undo the conversion.

This ability to recharacterize the conversion allows you to use hindsight to check whether your assets declined in value after the conversion. Since you are paying taxes on the amount converted, a decline in asset value means that you paid taxes on phantom income that no longer exists. However, if you convert assets into multiple Roth IRAs, you can choose to recharacterize the assets in a Roth IRA that decreased in value, while maintaining the conversion for a Roth IRA’s assets that appreciated in value.

The use of a Roth IRA can be a savvy investment, but whether to convert assets is not an easy decision. If you would like to explore your options, please contact this office.

How Do I? Recharacterize a Roth conversion, and why would I want to?

If you converted your traditional IRA to a Roth IRA earlier this year, incurred a significant amount of tax liability on the conversion, and then watched as the value of your Roth account plummeted amid the market turmoil, you may want to consider undoing the conversion. You can void or significantly lower your tax bill by recharacterizing the conversion, then reconverting your IRA back to a Roth at a later date. Careful timing in using the strategy, however, is essential.

What is a recharacterization?

“Recharacterization” is simply the term given to the transaction in which you undo your original conversion from a traditional IRA to the Roth. Even if you converted your entire account to a Roth, you do not need to recharacterize the entire amount that you converted from your traditional IRA to the Roth and can choose to only recharacterize a portion of the amount. To roll the money back and then forward into new Roth IRA, you must undo the original Roth conversion, wait at least 30 days (discussed in further detail, below) and then reconvert the IRA back to the Roth. This move may save you significant tax dollars since your IRA account is worth less due to the decline in market values.

Note. Roth IRAs are currently - but temporarily - restricted to taxpayers with adjusted gross incomes (AGI) that do not exceed certain amounts. For example, for 2008 Roth IRAs can be established by individuals with a maximum AGI of $116,000 ($169,000 for joint filers and heads of household). This restriction is completely lifted in 2010, when the AGI and filing status restrictions are eliminated.

Example. In June 2008, you converted your entire traditional IRA account balance of $200,000 to a Roth. However, the market has taken a toll on your account and it has declined in value and now in December is worth $100,000. Say you are in the 25 percent tax bracket — the conversion would have left you with a $50,000 tax bill (since conversion amounts, in this case $200,000, are taxed at ordinary income tax rates). However, if you recharacterize and convert the $100,000 account back into a Roth after meeting the timing requirements, you will owe only $25,000 in taxes on the conversion.

Reasons for recharacterization

Recharacterizing a Roth conversion may be appropriate for many reasons, especially if your Roth account has lost significant value but you have a large tax bill for the conversion, which perhaps may even be more than the amount currently in your account. You might also want to consider undoing the conversion if you cannot afford the tax bill due, the conversion will propel you into a higher tax bracket, or subject you to the alternative minimum tax (AMT).

What is required

The recharacterization of a Roth conversion must meet certain requirements. The conversion must be completed by your tax filing deadline (typically April 15). If you converted an IRA in 2008, you have until October 15, 2009 to recharacterize the Roth conversion. However, you will then have to wait at least until the year after you originally converted the IRA to reconvert the account back to a Roth, or at least 30 days after the recharacterization (whichever is later). Essentially, if you converted your traditional IRA into a Roth in 2008 you will have to wait until 2009 to convert the funds back into a Roth account.

Notice

For the recharacterization to work, you will also have to provide notice to the financial institution(s) which is the trustee of your IRA accounts and the IRS before the date of the trustee to trustee transfer (a recharacterization is generally done in a trustee-to-trustee transfer). The notice generally includes information pertaining to the date of applicable transfers, type and amount of contribution being recharacterized, and will need to be attached to your tax return Form 8606, Nondeductible IRAs, with a statement explaining the recharacterization.

Net Income Attributable (NIA) to the conversion

A recharacterization must also include the transfer of any net income attributable (NIA) to the contribution amount. NIA is generally any earnings or losses attributable to the converted amounts in the account. If the Roth IRA that you are recharacterizing consists only of the amounts originally converted from the traditional IRA, there is generally no need to compute NIA. Generally, NIA must be computed when less than the entire account balance is being recharacterized, your Roth includes amounts from other transaction such as a Roth IRA contribution (made after the conversion to the Roth), or the Roth includes funding from another Roth IRA conversion. The financial institution that has custody of your Roth may offer a service to help you compute your NIA, or talk with your tax advisor for help.

If you would like further information on Roth conversions or reconversions, please feel free to contact this office. As explained, there are time periods and deadlines that must be met, so procrastination may prove expensive in some situations.