Just as 2010 may have been the year of the Roth conversion, 2011 may be the year of the Roth re-characterization. Some clients had sticker shock after seeing the tax bill on their 2010 Roth conversions and want to undo those conversions. That may not be the best move. Before they re-characterize, make sure they take the following into consideration:
Don't let the tax bill scare you. Even though there is tax owed on the 2010 Roth conversion, the income can be spread over two years (2011 and 2012), lessening the amount of tax owed. Additionally, the tax payments can be deferred for two and three years. Clients actually can pay less tax and have more time to pay it. That means holding on to their money longer while earning tax-free income in their Roth individual retirement accounts.
THROWING AWAY GAINS
In addition, the stock market has rewarded most investors in 2010 and thus far in 2011, which means that tax-free gains already have been locked in. Explain to clients that if the Roth conversion is undone, these tax-free gains will be transferred back to a traditional IRA, where they will be taxable when withdrawn. That only benefits Uncle Sam. Make sure that the client sees the long-term big picture and doesn't let the tax bill overshadow the tax-free income already earned. The client pays tax only on the amount originally converted, even if the Roth IRA account balance is much higher now.
Don't blow the two-year deal. If a 2010 Roth conversion is re- characterized, the two-year (2011 and 2012) tax deal is lost for good, even if the same funds are reconverted in 2011. Once those funds are reconverted this year, the conversion is now a 2011 conversion and the two-year deal isn't available. All the 2011 Roth conversion income must be reported in 2011.
Hang on — you still have time. Even though 2010 tax returns were due April 18, your client still has until Oct. 17 to re-characterize a 2010 Roth conversion. So why rush? Why not take an extra few months to see how the Roth investments do? Maybe the added time will allow clients to re-evaluate their decisions. If they still want to undo the 2010 conversion, they can always re-characterize up to Oct. 17 and report the re-characterization on an amended tax return.
Required minimum distributions will increase. Once a 2010 Roth conversion is re-characterized, the funds are treated as if they never left the traditional IRA. If the re-characterization is done in the year after the conversion, the Dec. 31 year-end IRA balance reported on the account statements won't be correct. If a client is subject to required minimum distributions, that balance must be increased by the amount of the re-characterization.
Here is an example. Joe, 75, is taking required minimum distributions from his IRA. He is calculating his 2011 required minimum distribution, which is based on his Dec. 31, 2010, IRA balance of $500,000.
In addition to taking his required minimum distribution in 2010, he converted $100,000 to a Roth IRA. For whatever reason, Joe has decided to undo his entire 2010 Roth conversion.
Once he re-characterizes and the funds go back to his traditional IRA, his 2011 required-minimum-distribution calculation will change. He must add back the Dec. 31 value of his Roth conversion that he re-characterized; his 2011 RMD will be based on both a Dec. 31, 2010, IRA balance of $500,000 and the value of his Roth balance, even though his IRA statement will show a balance of $500,000.
You may not be able to re- characterize the entire conversion. When some clients converted in 2010, they didn't have funds outside the IRA to pay the tax. So they held back some of the converted funds to pay the tax. That is generally a mistake, and one we urge people to avoid at all costs. This is even more of an issue if the client was younger than 591/2, because that also would make any funds not converted subject to the 10% early-withdrawal penalty.
If they now want to undo the conversion, they can't re-characterize the amount withheld for taxes, so they will owe tax anyway — and maybe a 10% penalty on the funds not converted.
Ed Slott, a certified public accountant, created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. He can be reached at irahelp.com.
