For the first time, anyone with tax-deferred accounts had the opportunity to convert all or part of their accounts to Roth IRAs. (Before 2010, taxpayers with Adjusted Gross Income (AGI) of at least $100,000 weren’t allowed in the Roth sandbox.) We also were given the one-time-only option to defer taxes on 2010 conversions until the following two years.
If you converted funds to a Roth, Oct. 17 is an extremely important date for you. Because Oct. 15 falls on a weekend, the 17th is the last day that you can recharacterize any part of your conversion. Even if you didn’t recharacterzie, but have tax-deferred accounts (including those with your employer) this article has relevant information.
The terminology can be confusing, but the topic is important.
A Roth conversion is the process of taking money out of your IRA account in order to put it into a Roth IRA account.
When you move contributions from your deductible IRA to a Roth IRA, you pay income taxes on the amount you convert.
This is because you pay tax on IRA distributions when you take money out of your account. You must pay your tax by the due date of the tax return that you file for the year in which you convert the funds.
So, if you convert funds to a Roth IRA in 2011, the tax on the conversion is due by April 15, 2012. It’s important to realize, however, that the government gives you a do-over opportunity, called a recharacterization.
The deadline for electing to recharacterize is the extended due date of your personal income tax return, typically Oct. 15.
It is important for you to take another look at your conversion before this deadline passes because it gives you one last chance to undo your decision to convert to a Roth IRA. In light of the recent market drops, you want to be absolutely sure that you are comfortable with your conversion.
For example, if your Roth IRA is worth less now than when you converted, you will have to pay tax on the amount of the Roth IRA account transferred.
To be clear: if you converted $250,000 from your traditional IRA to a Roth IRA in 2010, and your Roth is worth $150,000 on Oct. 17, you will owe tax on $250,000 of income rather than the current $150,000 account balance. That probably isn’t palatable to most taxpayers. The decision to recharacterize, however, is anything but cut-and-dried.
Anyone who has a retirement account may choose to convert this year and into the future. Please discuss whether it would be appropriate to do so with your tax or financial advisers.
What you should know before deciding:
• If your account is down just a few points, but you’ve chosen the two-year payment spread, you’ll lose the opportunity to delay paying taxes if you recharacterize.
• If you’ve decided to recharacterize, but your account has grown in value since the conversion, realize that you are giving up tax-free gains that you may never get back.
• When the market goes down, consider converting more to your Roth IRA.
• Even if you’ve already filed your income tax return, you can amend it if you decide to recharacterize after filing.
• Wait until near the deadline to recharacterize since the markets may rise unexpectedly.
• You don’t have to recharacterize the entire conversion and the money does not have to go back to the same account from which it came.
• You are not allowed to take possession of the money when recharacterizing. Only “trustee-to-trustee” transfers are allowed. You are not allowed to withdraw the money, hold it for up to 60 days, and then deposit it in a traditional IRA (as you can do when moving money between traditional IRAs).
• Any funds recharacterized can be re-converted late in the calendar year after the conversion, or 31 days after the recharacterization.
We assess all prior-year Roth conversions a month before the annual recharacterization deadline so that we can review the tax and deferred income implications with clients during the last half of September. This gives us the opportunity to help make the decision to keep or purge (recharacterize) the conversion. If you converted funds to a Roth IRA in 2010, or at any time in the future, I recommend you do the same.
All these conversions, recharacterizations, and re-conversions are confusing, even to professionals. If you have questions about your IRAs, please give us a call. We’re here to help.
Johanna Fox Turner, CPA, CFP, RLP, is CEO of Milestones Financial Planning, LLC in Mayfield. She is president of Johanna Fox, CPA and publishes a free monthly financial newsletter (email email@example.com to subscribe). Contact Turner at firstname.lastname@example.org, 270-247-0555, 800-991-2721, or at www.milestonesfp.com.