Roth IRA - Part VI

Death & Taxes

Roth IRA, Part VI

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By Roy Lewis

We've discussed when and how you can make Roth IRA contributions and conversions, your related income tax issues, and the penalties involved when you take an "early" distribution from your Roth IRA. But, what happens when your best-laid plans fall apart and you find that a completed Roth IRA contribution and/or conversion now can't be made because your Adjusted Gross Income (AGI) unexpectedly climbed over the allowable limits? Is your goose cooked? Not in the least.

Failed Contributions and Conversions

Let's talk about your options when you find yourself in such a pickle by starting with an example.

Example #1: In January 2000, Tyler made a $2,000 contribution to his Roth IRA. Tyler was certain his 2000 AGI would be less than the $95,000 limitation (for a single filer), allowing him to make a full $2,000 Roth IRA contribution. Well in December 2000, Tyler's employer gave him a very large and unexpected bonus. That shot his AGI up well above the allowed limit for making a Roth IRA contribution. His Roth IRA, because of some Foolish investments, is now worth $10,000. What are his options?

Tyler really has two options:
  1. He can remove his Roth IRA funds. If he elects this option, he'll be required to pay taxes and penalties on the $8,000 of "earnings" from the Roth IRA since inception. Period. Not a very attractive option.

  2. Or Tyler can "recharacterize" his Roth IRA back to a traditional IRA. What this simply means is that he can transfer the ENTIRE balance of his Roth IRA to a traditional IRA. Will Tyler owe any tax on this transfer? Nope. Any penalties? Nope. Will he have to sell his stock to make this recharacterization? Nope.
Will he receive a tax deduction for his original $2,000 contribution (since that contribution will now be made to a traditional IRA rather than a Roth IRA)? Possibly. But that answer depends on Tyler's AGI and if he participates in a qualified pension or profit-sharing plan. We discuss this in much greater detail in my article on IRA Deduction Limitations.

But, even if the traditional IRA contribution is not deductible, Tyler can still get away with keeping his IRA "earnings" tax-deferred, and can avoid paying any current taxes or penalties on an early distribution. It's really pretty simple.

And, the same theory holds true for conversions.

Example #2: Annette makes a $20,000 conversion from her traditional IRA to a Roth IRA in 2000. When she does her taxes, she finds that her AGI exceeds the $100,000 allowable to make such a conversion. What does she do now? Simply recharacterize that conversion (and any earnings thereon) back to a traditional IRA account. Simple as that. Will she owe any taxes? Nope. Penalties? Nope.

But, there is one very important thing to remember: the recharacterization must take place by the due date of your tax return, including extensions. In both of the examples above, the recharacterization must be completed prior to October 15, 2001, and not one day later (adjust the years to fit your situation, as appropriate -- the deadline is the October 15th following your mid-April tax return filing deadline for the prior tax year). And, oddly enough, this "drop dead" date is in effect regardless of the actual date that you file your tax return. In either of the examples above, the actual tax return could have been filed in April 2001, but the "drop dead" recharacterization date remains October 15, 2001.

So, what happens if you wait until after the mid-October deadline to make your recharacterization? About the worst thing that could happen -- you'll be required to close the account and pay taxes and penalties on any "early" distributions -- which is why I call it the "drop dead" date. If you don't comply, you could drop dead when you find out how much you'll have to cough up in taxes and penalties.

Roth IRA Conversion Issues

You may be wondering, "How may times can I convert, then recharacterize, then reconvert an IRA to a Roth IRA, and vice-versa?"

During the 1998 doldrums in the market, after a number of IRAs had been converted, many people decided to recharacterize their Roth IRA back to a regular IRA, and then "reconvert" back to a Roth IRA to save substantial tax dollars. And, then they did it again... and again... and again. Uncle Sammy wasn't pleased.

Part of the problem was that the original law did not contemplate this type of tax-saving transaction. The recharacterization rules put in place with the 1998 tax law changes were designed to provide relief to people who converted their Roth IRAs early in 1998, and subsequently found that their AGI would exceed the $100,000 limitation. The lawmakers hadn't realized that some people would make these recharacterizations simply to save tax dollars. (Wow. How out of touch can the people in Washington really be?)

But, finally Uncle Sam recognized that some individuals might just arrange their affairs to reduce their taxes, and addressed this very issue with regulations prohibiting these transactions.

If you convert a traditional IRA to a Roth IRA in 2000 or later, and then recharacterize it back to a traditional IRA, you may not reconvert that amount back to a Roth IRA before the later of:
  • The beginning of the year following the year in which the amount was originally converted to the Roth IRA; or

  • The end of the 30-day period following the day on which you recharacterized the Roth IRA back to a traditional IRA.
Any reconversion made before the later of these two dates would be deemed a "failed" reconversion, and would be subject to the failed reconversion rules described above.

Example #3: Aileen has a traditional IRA that she converts to a Roth IRA in May 2001. She then recharacterizes that Roth IRA back to a traditional IRA on August 10, 2001. She then wants to make a reconversion back to a Roth IRA, but she has restrictions. She can't make that reconversion until the later of:

January 1, 2002 (the beginning of the year following the year in which the amount was originally converted to the Roth IRA); or

September 10, 2001 (the end of the 30-day period following the day on which she recharacterized the Roth IRA back to a traditional IRA).

Since she must wait until the later of these two dates, Aileen has to hang on until at least January 1, 2002. If she decides to go ahead and make the reconversion before January 1, 2002, it will be treated as a "failed" reconversion and will be subject to the failed reconversion rules.

Simple? Nope. Easy? Not quite. Understandable? Hardly. All we can hope is that if you have played the "conversion" game with your IRA/Roth IRA, you now understand the rules. If not, you could be in for a very, very rude awakening come tax-filing time.

Part VII is the final installment in this series and we'll discuss the burning question: Should you convert your traditional IRA to a Roth IRA? We know you can't wait.
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