I'll Take a Mulligan Please -

Time to Re-Evaluate Your

2010 Roth IRA Conversion

Mark Miller, CPA, Shareholder - Tax   email | bio
October 2011

Many taxpayers took advantage of the tax law change that took effect in 2010 allowing Roth IRA conversions without regard to income level. There are many reasons to consider a Roth IRA conversion, one of which is the ability to recharacterize (un-convert) the Roth IRA conversion if your circumstances change and/or the value of the Roth IRA drops in value.

The ability to recharacterize a Roth IRA conversion extends until October 15 of the year following the conversion. This deadline applies whether the tax return for the year of filing has been filed or if the tax return is on extension. Therefore, taxpayers converting an IRA to a Roth IRS in 2010 have until October 17, 2011, to recharacterize the 2010 conversion.

With the volatile stock markets in 2011 and depending on when the 2010 conversion occurred, many taxpayers may find their Roth IRA account values to be lower today than when the conversion occurred. These taxpayers may benefit from a recharacterization. If you choose to recharacterize the Roth IRA conversion you initially made in 2010, you would need to contact the custodian of your Roth IRA (e.g. broker or investment adviser, mutual fund company, etc.) and indicate the amount of the Roth Conversion that you would like to recharacterize. The amount recharacterized must include any earnings (positive or negative) that occurred during the time the assets were in the Roth IRA. Your investment adviser will guide you through the paperwork process. You will also have to report the recharacterization on your original or amended 2010 tax filing.

If a taxpayer chooses to recharacterize the Roth IRA, it does not prevent a new conversion of the same IRA account. The tax laws only require that you wait the longer of: (1) the tax year following the conversion; or (2) 30 days after the date of the recharacterization - and then play the game all over again. For the golfers out there, this is equivalent to a free mulligan (i.e., the player gets a second chance to perform a certain move or action).

For example, let's assume you converted an IRA account to a Roth IRA in 2010 when the IRA was valued at $200,000, and the account value today is $180,000. If nothing is done by October 15, 2011, you will pay income taxes on $200,000 for IRA assets only worth $180,000 in value. If instead, you recharacterize the Roth IRA back to a traditional IRA on or before October 15, 2011, and then wait 30 days and reconvert to a Roth IRA when the IRA is valued at $180,000, you would reduce the taxable income reportable on the conversion to $180,000. If you are in a 35% combined federal and state tax bracket for each of these tax years, you could save approximately $7,000 in taxes.

The analysis of whether or not to recharacterize the Roth IRA back to a traditional IRA can be involved, and should take into account a number of considerations. Following is a noninclusive list of the factors to consider.

Reasons to Consider a Recharacterization:

1. If the value of the converted assets is lower than at the time of the original IRA conversion, the recharacterization followed by a second conversion could reduce your overall tax bill.

2. Even if the value of the IRA has stayed the same or increased slightly, some taxpayers may want to recharacterize and reconvert to have another opportunity to evaluate the future investment performance of the IRA account and create another recharacterization opportunity in the future. For example, if you recharacterized the account now and re-converted in 30 days, you would be able to do another recharacterization up to October 15, 2012, should the account decline in value between now and next October 15th (i.e., a second Mulligan).

3. Some taxpayers may have had a change in circumstances that might suggest your income tax bracket may be lower in 2011 or 2012 if you recharacterize and then re-convert. This might suggest a different game plan than splitting the Roth IRA conversion income equally between 2011 and 2012 under the special election available in 2010.

4. You are contemplating changing residency to a state that would not tax a Roth IRA conversion. By recharacterizing the 2010 conversion and doing a second conversion after establishing residency in another state, you could save substantial state income taxes.

Reasons Not to Recharacterize a 2010 Roth IRA Conversion:

1. A special provision in the tax laws allows a taxpayer to report the income from a 2010 Roth IRA conversion equally in 2011 and 2012. This provision is not available if a taxpayer would recharacterize a 2010 conversion and re-convert in 2011 or 2012. Having the conversion income all taxed in 2011 or 2012 upon a second conversion could affect the tax rate applicable to the conversion income.

2. If the Roth IRA account is down only slightly, the requirement that you must wait 30 days after recharacterization could result in you paying tax on a larger amount if the investments within the IRA increase in value during that 30 day wait period.

It is prudent for taxpayers that engaged in a Roth IRA conversion in 2010 to review their particular circumstances including: obtaining the current value of the Roth IRA account; projecting income tax rates for 2010, 2011 and 2012; and addressing other relevant factors to determine whether a recharacterization is beneficial. If you have any questions regarding your individual tax situation and options, please contact your Kolb+Co. tax adviser. Fore!