|Reconverting a Roth That Declined in Value?
How to re-characterize Roth IRAs.
March 11, 2010
In response to reader questions from an earlier article, this article provides an extended example of reconverting a Roth that had declined in value and answers selected additional conversion questions.
Three Roth Re-characterization Examples
If funds converted to a Roth subsequently decline in value, a taxpayer effectively pays a conversion tax on investment losses. To offset this risk, the Internal Revenue Service (IRS) allows taxpayers to re-characterize (undo) all or part of the transaction up until the extended due date of the return for the year of conversion. Because income or loss is determined by account, and not by specific investment, one strategy is to set up a separate Roth account for each investment category (stocks, bonds, commodities, etc.) and only re-characterize the accounts that decline in value. The three examples below illustrate this strategy, but advisors should also refer to Reg. Sec. 1.408A-5 and IRS Notice 2000-39 for detailed explanations.
Re-characterization Example 1 — Convert to Roth, then re-characterize entire amount.
Nancy has $100,000 in a traditional individual retirement account (IRA) funded entirely by her deductible contributions. She converts the IRA to a Roth on January 10, 2010. Six months later the account declined in value to $90,000, and Nancy decides to undo the entire conversion. In this case, the entire balance in the Roth ($90,000) is transferred back to a traditional IRA and she re-characterizes the entire $100,000 conversion. However, in situations in which only a portion of the Roth account is re-characterized, the amount transferred back to the IRA equals the Re-characterized Amount (RA) plus or minus the income that amount earned while invested in the Roth. The regulations define the relevant terms; a simplified formula follows:
Transfer (T) = RA X (1 + r)
where r = (Closing Balance – Opening Balance)/Opening Balance.
In this example,
T = 100,000 x (1 + (90,000-100,000)/100,000) = 100,000 x 0.9 = 90,000.
Because the conversion was entirely re-characterized, Nancy reports no income as a result of the conversion and re-characterization.
Example 2 — Convert to Roth, re-characterize only part of the conversion.
Assume the same facts, but that Nancy invested the $100,000 as follows: $50,000 in Stock A and $50,000 in Stock B. At the end of six months, Stock A is worth $60,000, but Stock B has declined to $30,000. Nancy directs her broker to sell only Stock B and transfer the proceeds back to her traditional IRA. In this case, we know the amount to be transferred back to the IRA is $30,000, but we must solve for the amount re-characterized for income tax purposes.
Transfer = RA x (1 + (90,000 – 100,000)/100,000)
$30,000 = RA x (1 – 0.1) = 0.9RA
RA = 30,000/0.9 = $33,333.
Note that the gain or loss calculation takes into account the gain or loss of the entire account, not just the investment sold. Because only one-third ($33,333) was re-characterized, Nancy will report $66,667 ordinary income from the Roth conversion.
Example 3: Assume the same facts, except that Nancy established two Roth accounts and funded each with $50,000. Roth1 was invested solely in Stock A and Roth2 invested in Stock B.
As in the previous example, Stock B declined to $30,000 and Nancy asked her broker to sell her entire position and liquidate Roth2. Note that Nancy only looks at the income or loss in Roth2.
$30,000 = RA x (1+(30,000 – 50,000)/50,000) = RA (1 -0.4) = 0.6RA.
RA = 30,000/0.6 = $50,000.
Compare the results of Examples 2 and 3. From an economic standpoint, the transactions are identical — Nancy liquidates a losing stock position of $30,000 held in a Roth and transfers the proceeds back to her traditional IRA. However, because Nancy established two accounts in Example 3, the amount she ultimately reports in conversion income totals only $50,000 rather than $66,667 in Example 2.
Three Additional Issues With Roth Conversions
Issue 1: Taxpayer has an IRA with a balance of $50,000. She has a $6,000 basis in the account due to non-deductible contributions. Can she roll over just the non-taxable basis to a Roth?
The general answer is no. Distributions from IRAs are ratably attributed to the taxpayer’s basis, if applicable. In this example, only 12 percent ($6,000/$50,000) of any distribution from the IRA is normally excludible from tax. However, Natalie Choate, in Life and Death Planning for Retirement Benefits, highlights an exception if the taxpayer is a participant in a qualified retirement plan (QRP, e.g. 401(k) plan) or 403(b) plan that accepts IRA rollovers. Since a QRP cannot accept rollovers of non-deductible contributions, the taxpayer can distribute the $44,000 taxable portion of the IRA balance to the QRP, leaving an amount equal to her basis in the IRA. The remaining balance of $6,000 can then be rolled into a Roth tax free. Note that the taxpayer’s investment options will decrease and fees might increase when moving from the self-directed IRA to a company-sponsored QRP. On the other hand, going forward, a taxpayer above the adjusted gross income (AGI) limits for funding a Roth can avoid the AGI restrictions by funding a traditional IRA with non-deductible contributions and immediately converting the amount to a Roth.
Issue 2: Taxpayer is 76 and has a traditional IRA with a balance of $200,000 as of December 31, 2009. Her required minimum distribution (RMD) for 2010 is $9,100. She plans to convert the entire account to a Roth IRA. Since the entire balance in her IRA will be taxed at conversion, does she still need to make a RMD?
Yes, the taxpayer must first distribute, and cannot roll over, the required minimum distribution for 2010. See Reg. Sec. 1.402(c)-2, A-7(a). The remaining balance at the time of conversion ($190,900 assuming no investment gain or loss) can then be converted to a Roth IRA. Note that after the conversion, taxpayer no longer is required to take annual RMD from the Roth.
Issue 3: Taxpayer has an existing balance in a 401(k) plan (or other qualified plan). Can she roll that amount directly into a Roth IRA or must she first form a traditional IRA to accept the 401(k) funds then convert the traditional IRA to a Roth?
IRS Notice 2008-30 makes it clear that if an amount from a qualified plan can be rolled over to an IRA, it can be rolled over directly, without the intervening step of placing the money temporarily in a traditional IRA.
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LeAnn Luna is an associate professor of accounting and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.