For clients who made Roth IRA conversions last year, Oct. 15 is the last day that they can undo those conversions via a Roth re-characterization.
If the value of the Roth individual retirement account has declined substantially, it often makes sense to re-characterize the conversion to recoup the tax paid on value that no longer exists, perhaps with an eye on reconverting in the future.
For the first time since the floodgates opened on Roth conversions in 2010 — when the Roth conversion restrictions were repealed — the majority of Roth IRAs being evaluated for re-characterization should be up in value.
That is good news for clients who see the potential long-term benefits of the Roth IRA and good news for financial advisers, who may be able to cut down on the paperwork they slogged through a year ago.
Another potentially unique aspect of this year's deadline is that the “low” federal income tax rates that clients have enjoyed for 10 years may soon be coming to an end.
As it stands, income tax rates are set to increase next year, with the top rate going to 39.6% from 35%. Add in the 3.8% surtax on net investment income slated to kick in at the start of the year, and high-income clients could pay as much as 43.4% in federal income tax alone.
A re-characterization could make sense, but clients should still be mindful that such a transaction might ultimately lead to a greater tax burden in the future.
If a re-characterization of a 2011 Roth conversion makes sense now but the Roth IRA is still desired long term, clients still can lock in the low rates.
Any 2011 Roth conversion re-characterized by the deadline can later be reconverted back to a Roth this year, guaranteeing that the tax on the conversion will result in no more than a 35% federal income tax hit.
WAIT A WHILE
Don't convert back right away, though. A 2011 conversion re-characterized this year can be reconverted back to a Roth IRA only after 30 days have passed.
Although there are many reasons for clients to consider forgoing a re-characterization, there are also many reasons the move might make sense.
Maybe they had unexpectedly high income last year, pushing them into a higher-than-expected tax bracket. Maybe they ran into some hard times and couldn't come up with the money to pay the tax on the conversion.
Or maybe they had Roths that went down in an up market.
Another reason to re-characterize is because clients may have forgotten about the 2010 Roth conversion that they did. If they took the two-year deal, as most did, their 2011 tax return may include more income than they counted on and now they can't pay the tax on both the first half of the 2010 conversion and the 2011 conversion.
They can't undo the income from the 2010 conversion. Even though that income appears on their 2011 tax return, the deadline to re-characterize a 2010 conversion was last Oct. 15.
The 2011 converted funds, though, can still be re-characterized.
If your clients have filed their 2011 tax return already, they should contact their tax professionals and have them file an amended return. Upon filing an amended return, clients will receive a refund of any overage paid, plus interest.
That isn't a bad deal when you realize that the applicable interest rate this year has been an annualized 3%.
Clients also should file an amended state tax return, too, for any refunds applicable there.
If your client hasn't yet filed a return, they must file their normal return by the Oct. 15 deadline, showing the net amount of the conversion.
Clients should follow the general Roth re-characterization rules, such as making sure that the re-characterization is completed by the deadline, that the correct amount goes back to an IRA only and never to a plan, and that the funds are moved from the Roth IRA to the IRA in a trustee-to-trustee transfer.
If the re-characterization is done wrong, clients can end up owing income tax and have no Roth — or IRA, for that matter.
The amount transferred is the amount of the conversion desired to be re-characterized, plus or minus the gains or losses attributable to the funds while they were in the Roth.
Inherited converted Roth IRAs can also be re-characterized, but they can never be reconverted because inherited traditional IRAs can't be converted to inherited Roth IRAs.
Ed Slott (irahelp.com), a certified public accountant, created The IRA Leadership Program and Ed Slott's Elite IRA Advisor Group.