ReCharacterization of IRA Contributions or Roth Conversions
(March 23rd, 2008)
Recharacterization is when a 401k participant
switches from a Traditional IRA plan to a Roth IRA plan, and due to
various # of reasons, switches back to the Traditional IRA plan.
When making IRA recharacterizations, individuals have to calculate their
earnings and losses on the original value of their Roth Conversions
or IRA contributions. It is imperative that these earnings/loss calculations
are done correctly otherwise the tax consequences can be severe.
First, the deadline for Recharacterization
of a Roth Conversion of IRA Contribution is your tax-filing deadline
(April 15th of each year). However, you are eligible to receive
a 6 month extension on Recharacterizations which means your deadline
is Oct 15th of each year. For example, if you want to Recharacterize
a 2004 IRA contribution you made, your deadline is October 15th, 2004.
Why Would I want to Recharacterize my Roth Conversion?
A taxpayer can choose to recharacterize his
Roth Conversion for reasons such as:
* For example, when Roth IRA assets are converted,
the taxable amount of the conversion is the initial value when the assets
are converted, even if these assets have declined in value. For
instance, if a taxpayer converted his IRA assets worth $120,000 in April
of 2004, and these assets have since decreased in value to $40,000, the
individual will still have to pay taxes on the initial $120,000 he deposited
in April of 2004. Who said tax rules are fair!?
Why Would I want to Recharacterize my IRA Contribution?
A taxpayer can choose to recharacterize his IRA Contribution
for reasons such as:
- An individual can recharacterize his Traditional
IRA contributions into Roth IRA contributions due to tax-free accumulation
and accrual of earnings.
- An individual can recharacterize his Roth
IRA into a Traditional IRA in order to be eligible to make tax deductions
on the amount.
How Do I Recharacterize my Roth Conversion of IRA Contributions?
In order to recharacterize your IRA, you must
move all the retirement savings and assets from the original IRA into
your new IRA plan. Your financial institution can simply do this
move by changing the type of IRA, for example from a Traditional IRA into
a Roth IRA. Check with your financial institution as to their requirements,
plus all the documentation you will need to successfully recharacterize
your IRA.
How do You Calculate Earnings/Losses on a Roth IRA
Recharacterization
The IRS on May 5th, 2003 finalized the Treasury
Rules (T.D. 9056) regarding calculation of earnings or losses on a Roth
IRA Recharacterization. These rules apply to recharacterizations
made on or after January 1st, 2004 but IRA participants have the option
to apply these rules to any recharacterizations made in the years 2002
and 2003 as well.
The formula for calculating the Earnings/Losses on
an IRA Recharacterization is:
| Net
Income = |
Contribution
x |
(Adjusted
Closing Balance - Adjusted Opening Balance)
Adjusted Opening Balance |
Here is what these terms mean:
- Net Income = Earnings or Losses
on the Total Recharacterized Amount
- Contribution
= Amount being recharacterized
- Adjusted Opening Balance = Fair
market value of the IRA at the beginning of the Recharacterization computation
period + any contribution amounts + transfers.
- Adjusted Closing Balance = Fair
market value of the IRA at the end of the Recharacterization computation
period + any distributions taken out + any transfers or other recharacterizations
within the period.
Real Life Example of a Roth IRA Recharacterization
Imagine a taxpayer named John has $105,000 in his Roth
IRA. In October of 2003, John converted his Traditional IRA valued at
$150,000 to his existing Roth IRA. However during the taxation year of
2003, John received a company bonus of $20,000 on top of his compensation
wage of $90,000 a year. This means he is NOT eligible for a Roth IRA conversion
because his combined Adjusted Gross Income is more than $100,000, for
the year 2003. Therefore, in March 2004, John recharacterizes his Roth
IRA back to a Traditional IRA valued at $240,000. Since there were no
distributions taken out from the Roth IRA, nor were there any contributions
made, the following is used to calculate the Net Income:
| Net
Income = |
Contribution
x |
(Adjusted
Closing Balance - Adjusted Opening Balance)
Adjusted Opening Balance |
| Net
Income = |
$150,000
x |
(240,000
- (105,000 + 150,000))
105,000 + 150,000 |
| Net
Income = |
$150,000
x |
(240,000
- (255,000))
255,000 |
| Net
Income = |
$150,000
x |
-
15000
255,000 |
| Net
Income = |
$150,000
x |
-
0.0588 |
John therefore has a net loss of $8,820 on the Roth
IRA Recharacterization. He therefore can recharacterize no more than ($150,000
- 8820) = $141,180
|
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Roth IRA Contribution Limits |
| Year |
Regular Contributions |
Catch Up Contributions |
| 2001 |
$2000 |
$0 |
| 2002 |
$3000 |
$500 |
| 2003 |
$3000 |
$500 |
| 2004 |
$3000 |
$500 |
| 2005 |
$4000 |
$500 |
| 2006 |
$4000 |
$1000 |
| 2007 |
$4000 |
$1000 |
| 2008 |
$5000 |
$1000 |
| 2009 |
$5500 |
$1000 |
|
Modified Adjusted Gross Income Limits
|
| Year |
Filing as Single |
Filing as Joint |
| 2001 |
$33,000 - $43,000 |
$53,000 - $63,000 |
| 2002 |
$34,000 - $44,000 |
$54,000 - $64,000 |
| 2003 |
$40,000 - $50,000 |
$60,000 - $70,000 |
| 2004 |
$45,000 - $55,000 |
$65,000 - $75,000 |
| 2005 |
$50,000 - $60,000 |
$70,000 - $80,000 |
| 2006 |
$50,000 - $60,000 |
$75,000 - $85,000 |
| 2007 |
$50,000 - $60,000 |
$80,000 - $100,000 |
|
Roth IRA Facts |
In Traditional IRA, the contributions you make towards the account
are not taxed. Whatever capital gains & earnings you make on
your IRA are also not taxed up until retirement, when you withdraw
money from your account. For example, imagine you made $50,000 this
year and contributed $5000 to a traditional IRA. You will be taxed
on $50,000 - $5000 = $45,000. Furthermore, your $5000 contribution
will grow tax-deferred for many years, until you retire and decide
to withdraw it.
Any 'qualified distributions'
you take from a Roth IRA will NOT be included in your taxable income,
hence making you exempt from paying taxes. You won't have to pay
taxes on the original principal you contributed nor any taxes on
capital gains & earnings you have accumulated. In order for
the distribution to be classified as 'qualified', it must be taken
under 1 of the following circumstances:
- the Roth IRA
investor must be 59 and 1/2 years or older at the time of the distribution
- the Roth IRA investor becomes disabled at the time of taking the
distributions
- the Roth IRA investor dies and his/her beneficiary receives the
assets contained in the plan
- the distributions taken from the Roth IRA will be used in the
purchase or building of a new home for the Roth IRA holder or qualified
family member. This is limited to $10,000 per person per lifetime.
Qualified family members include:
--> the Roth IRA investor
--> the Roth IRA investor's spouse
--> children of the Roth IRA investor
--> grandchildren of the Roth IRA investor
--> parent or ancestor of the Roth IRA investor
The law states that if your adjusted gross
income (AGI) is greater than $100,000, you cannot convert from a
traditional IRA to a Roth IRA. This law applies to both singles,
married filing joint & head of household filers. Note that if
you are filing a married-filing-separate tax return, you are not
eligible to convert a traditional IRA to a Roth IRA at all, no matter
what your adjusted gross income is. |
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