The Jury is Out on 2010 Roth Conversions
If you did a Roth IRA conversion in 2010, congratulations. The next smart thing to do is to review that decision and see if it still makes sense for your situation.
When a traditional IRA is converted to a Roth, all before-tax contributions made to the IRA become taxable; and the income tax must be paid. But once the money is in the Roth IRA, it grows tax-free; and the Roth IRA owner can make tax-free withdrawals at any time provided that five years has passed. For a Roth IRA, there are no minimum required distributions after you attain age 70½. This can be a tremendous advantage – tax-free growth and no minimum required distributions.
2010 was the first year that taxpayers with more than $100,000 of income could convert to a Roth IRA. During 2010 it looked like it could be the best year for taxpayers to do a Roth IRA conversion because of the scheduled tax increases in future years. In addition, after 2010, increasing income could cause a person’s investment income and wages to be subject to the new health care taxes. Since the 2010 Tax Reform Act passed mid-December 2010 and extended the Bush tax cuts for two years, the anticipated rise in income tax rates was not realized. Also, since the 2010 Tax Reform Act, the estate tax exemption is at an all-time high of $5 million, at least for 2011 and 2012.
Given these facts and the outlook for the economy both domestically and internationally, if you did a 2010 conversion, you should at least think about whether or not you should “undo” your Roth conversion, putting your money back in the traditional IRA where it started and maybe convert at a later time.
Recharacterization is the “undoing” of your Roth conversion.
To recharacterize a Roth conversion, you must move the assets from the IRA that first received the conversion to the traditional IRA in which you want the assets to be maintained. Some financial institutions will process the recharacterization by simply changing the IRA from one type to another. Check with your IRA custodian/trustee about their procedure and any documentation requirements for processing a recharacterization.
If a partial recharacterization is to be done, then it is very important to calculate the earnings (or losses) on the amount that is to be recharacterized. The IRS has a formula for determining this. The formula takes into account additions to the account as well as any distributions and arrives at a proportionate allocation of the account’s income and/or gain or loss.
Your IRA custodian will report your IRA contributions (to you and the IRS) on IRS Form 5498. This contribution will be reported even if it is later recharacterized, which means that if you recharacterize your contribution, you will receive two Form 5498s, one for the initial contribution and a second for the amount that is credited to the other IRA as a recharacterization. You will also receive a Form 1099-R for the IRA that first received the contribution. Form 1099-R is used to report distributions from retirement accounts. Your custodian will use a special code in box 7 of the Form 1099-R to indicate that the transaction is a recharacterization and therefore not taxable.
Partial recharacterizations must be reported on IRS Form 8606 filed with your tax return. You need not file form 8606 for full recharacterizations.
An IRA that has been converted to a Roth earlier in the year and then switched back (recharacterized to a traditional IRA) can’t be reconverted to a Roth again in the same year. The ‘reconversion’ has to be delayed until at least January 1 or if later, 30 days after the Roth IRA was recharacterized back to a traditional IRA.
Deadline For Recharacterizing
The deadline for recharacterizing a Roth conversion or IRA contribution is your tax-filing deadline plus extensions. You must give instructions to your Roth IRA custodian in advance so the transaction can be completed by the deadline. If you request an extension of time to file you tax return by April 18, 2011, you receive an automatic six-month extension, which means your deadline to recharacterize a 2010 contribution is October 15, 2011. By filing an extension request, you have the maximum time to see if you want to recharacterize, have your Roth IRA taxed in 2010, or half each in 2011 and 2012.