Since I haven't had any ideas for a good post (promise rainbow cake post will come soon), I thought I would share what a typical day at the office is for me. Below is what I get to research and write about, though it may not be on a daily basis. Have fun and don't fall asleep!
Recharacterizing an IRA Conversion
The IRS does not offer many “mulligans”, however, one is available with regard to Roth IRA conversions. For individuals eligible to invest in a Roth IRA, you can transfer assets from a traditional IRA to a Roth IRA by utilizing a conversion. A conversion is a taxable event during which funds are distributed from a traditional IRA and rolled into a Roth IRA either directly or within 60 days of distribution. Taxes are due on the value of pretax contributions and any earnings. The IRS allows individuals to “undo” the conversion by recharacterizing the converted funds back to a traditional IRA, thereby pulling the funds out of taxable status and according the individual a lower tax liability.
A Roth IRA is an individual retirement vehicle that allows individuals to set aside after-tax dollars. Earnings on contributions are not subject to income tax as long as you hold the account for at least 5 years and you are at least 59 ½. There is an early withdrawal fee of approximately 10% if you withdraw the money before 59 ½ and without a qualified reason. Be aware that if the distribution is not considered “qualified,” it is also subject to tax. Unlike a traditional IRA or 401(k), there are no required distributions. The principal restriction of a Roth IRA is the AGI income limitation that excludes high-earning individuals.
A Roth IRA is traditionally limited to individuals who make less than the AGI limit prescribed by the IRS in a certain year. For single filers, the AGI limit was $107,000 in 2011 and $110,000 in 2012; and for married filers, $169,000 in 2011 and $173,000 in 2012. In general, individuals are taxed (at current rates) on the entire amount converted, as these monies are moving from a pre-tax vehicle to a post-tax vehicle. However, the IRS allowed anyone who made a conversion in 2010 to defer income from 2010 and split the tax burden between 2011 and 2012. This exception was because, for one year only, the IRS made Roth conversions available to everyone, regardless of their AGI. (Note that the rule was changed for 2010 only and the traditional rules are back in place for any subsequent year, barring an act of Congress.)
An individual’s tax liability is determined based on the value as of the date of the conversion. If possible you should project the value in order to make sure there are available funds to pay the tax liability. Individuals should also consider if the value of the conversion will put them into another tax bracket, which would result in a much higher than desired tax liability. A conversion can also increase taxes on Social Security and affect the premium you pay for Medicare Part B, or it can trigger alternative minimum tax (AMT) rules. If you did not consider the above or did, but intervening events land you in a less than ideal spot after making the conversion, or if you just want to, the IRS allows you to “take back” or recharacterize part of the conversion. Recharacterizations of IRA conversions are available to anyone.
To recharacterize either all or part of the Roth conversion, you will need to transfer the recharacterized amounts to a new or existing traditional IRA via a trustee-to-trustee transfer. The IRS does not allow you to transfer the amount back into the plan from which they were originally distributed and the funds must pass from one financial institution to another or change accounts via an intra-institution transfer; the funds cannot enter your hands. You also cannot reconvert the amount recharacterized to the same or another Roth IRA until the later of 30 days after the recharacterization, or the year following the year of the rollover or conversion. However, this waiting period does not apply to amounts other than the ones you recharacterized. The deadline for recharacterizing a Roth conversion is your tax-filing deadline plus extensions. If you file the tax return on time (generally by April 15), you receive an automatic six-month extension, which means your deadline to recharacterize a 2011 contribution is October 15, 2012. You must report the recharacterization on your tax return as directed by Form 8606 and its instructions. Practice note: the recharacterization of a contribution is not treated as a rollover for purposes of the one-year waiting period.
For more information, you should speak to your financial advisor or tax preparer and review IRS Publication 590 and the Form 8606.
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