With income restrictions on conversions lifted beginning in 2010, Roth IRAs became accessible to affluent investors (specifically those with incomes greater than $100,000) for the first time. It’s reasonable to suggest that many of these investors are not well-versed in some of the intricacies of Roth IRAs, including the option of recharacterization. Now is an ideal time to review Roth IRA conversions that occurred during 2010 within your book of business, and contact clients to confirm they would like to keep the conversion in place. Roth IRA owners who converted during calendar year 2010 have until October 17, 2011 (the tax filing deadline plus extension), to decide if they want to recharacterize, or “undo,” a conversion. Typically, there are two reasons to consider recharacterizing a Roth IRA conversion:
(1) The investor realizes that the additional, taxable income from a conversion will have serious negative implications on their personal tax situation. Remember that the investor could always opt to recharacterize a portion of the conversion and allow some of the funds to remain in the Roth IRA.
(2) Since the conversion, the value of the Roth IRA has depreciated significantly. For example, assume an investor converted a traditional IRA valued at $100,000 during 2010 that is now worth only $80,000. From a tax perspective, the investor may want to recharacterize the conversion to avoid reporting $100,000 of ordinary income on an account that is now worth only $80,000. By recharacterizing, the investor could transfer the Roth IRA funds back into the traditional IRA without any taxes or penalties.
It’s important to remember that there are restrictions on converting traditional IRA assets to a Roth IRA after a recharacterization has occurred. If a recharacterization occurs in the same calendar year as the original Roth conversion, an IRA account owner has to wait until the (a) next calendar year or (b) 30 calendar days — whichever is longer — before converting again. In cases where the original Roth conversion occurred in the previous calendar year, the IRA owner would have to wait until 30 days after a recharacterization before converting those assets again. Regardless of whether your clients consider a recharacterization, this is a great opportunity to proactively engage them on their retirement and tax-related needs. Lastly, as always, it’s critical for clients to work closely with their tax professional regarding their personal circumstances.
For more information on recharacterization, download our Converting a Traditional IRA to a Roth IRA investor education piece.