Tax season is over, but now post-tax season fixes must be made, especially in the IRA area. Roth IRA conversions or contributions can be undone (technically called a “recharacterization”) up to Oct. 15 of the following year. But when that deadline is missed, it creates problems for clients because now they must get IRS approval to undo the error, by requesting a private letter ruling (PLR).
A recent ruling (PLR 201511022, released by the IRS on March 13) illustrates how mistakes can be reversed, but these rulings are costly and time consuming.
Most recharacterization rulings are to undo unwanted Roth conversions after the fact. However, annual traditional or Roth IRA contributions can also be recharacterized, and thus are potentially eligible for a late recharacterization PLR from IRS. In PLR 201511022, the IRS allowed late recharacterizations of Roth contributions because the couple's tax preparer never told them they weren't eligible to contribute to a Roth IRA due to their income being over the Roth IRA contribution eligibility limit.
Taxpayers we'll call “Al” and “Betty” are a married couple filing jointly who each had Roth IRAs and made monthly contributions from 1999 through 2012. In March 2013, they met with a CPA who looked over their Roth IRA contribution history and determined that from 2005 through 2012 they were not eligible to make Roth IRA contributions because their joint income exceeded the modified adjusted gross income (MAGI) phase-out limits in effect for those years.
(Note: Making Roth IRA contributions when MAGI exceeds the annual phase-out limits creates excess Roth IRA contributions that are subject to a 6% penalty unless corrected in a timely manner by either withdrawing it or recharacterizing it as a traditional IRA contribution.)
Al and Betty were never told about of any MAGI limits for contributing to a Roth IRA by their tax preparer, who had filed their tax returns for many years. In 2013, acting on the advice of their CPA, they each timely recharacterized their 2012 excess Roth IRA contribution as traditional IRA contributions for 2012 to avoid the 6% excess contribution penalty. However, it was too late to recharacterize the other excess Roth IRA contributions from 2005 through 2011 (i.e., they missed the Oct. 15 deadline for seven years' worth of excess Roth contributions).
They applied for a PLR asking to recharacterize all the excess Roth contributions as traditional IRA contributions.
The IRS granted their request for all the late recharacterizations. The IRS said that Al and Betty didn't know about the MAGI limits and that they relied on their tax preparer to advise them about the Roth IRA eligibility rules. As soon as Al and Betty were made aware of the problem by their new CPA, they requested the PLR before the IRS realized they weren't eligible to make the contributions. The IRS believed they acted reasonably and gave them 60 days from the date of the PLR to recharacterize all the excess Roth IRA contributions to traditional IRAs.
RECHARACTERIZATION BASICS
A recharacterization is a transaction that allows individuals to treat IRA contributions made to one kind of IRA as if it were made to a different kind of IRA. From a tax perspective, a recharacterization changes the original IRA contribution to different kind of IRA contribution. Anyone can do a recharacterization for any reason, and a partial recharacterization can be done. The recharacterization is one of the rare second chances granted by the tax code and allows great flexibility in a client's financial and tax planning. There are three primary types of IRA contributions that can be recharacterized:
1. Reversing (undoing) a Roth IRA conversion
2. Changing a traditional IRA contribution to a Roth IRA contribution
3. Changing a Roth IRA contribution to a traditional IRA contribution
The deadline is Oct. 15 to recharacterize a 2014 contribution or conversion even if the 2014 tax return has already been filed. If the return was already filed, then an amended return will have to be filed on Form 1040X (and an amended state tax return, if applicable) to receive a refund of any tax paid on a Roth conversion. Taxpayers have three years from the original due date (or extended due date) of the return to file an amended tax return.
The IRS has the authority to extend the time to recharacterize beyond Oct. 15 and has done that for many taxpayers who have requested private letter rulings. But the extension is generally granted only in cases where there is custodian or adviser error. The extension of time to recharacterize has never been granted solely because the value of the investments in the converted Roth IRA declined.
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.
