One of my clients who was 80 years old converted a portion of her traditional IRA to a Roth IRA early in March, 2009 when the Dow Jones Industrial Average (DJIA) had just climbed over the 7,000 mark after declining to an intraday low of 6,440 on March 9th. With the DJIA increasing by 4,000 points, or 57%, to 11,000 recently, and assuming it stays at this level, at least 57% of the value of my client’s IRA at the time of conversion that would have eventually been taxed had my client not done her conversion will permanently escape income taxation provided the market remains above 11,000 and she takes no distributions from her Roth IRA for five years from the date of her conversion.
With the market up almost 60% in a little over a year, many people are wondering if this is a good time to do a Roth IRA conversion. What happens if you do a conversion, you’re not as fortunate as my client, and the market does an about-face, descending below 10,000 again? This may not make much difference if the assets that you converted are not directly market-sensitive such as fixed income instruments. But what if your Roth IRA conversion assets instead consist of a diversified portfolio of small-, mid-, and large-cap individual stocks, mutual funds, and exchange-traded funds? That’s a different story.
Forgetting about the fact that you’re generally required to wait at least five years from the first day of the year in which you do a conversion to take a distribution from your Roth IRA in order to avoid a potential 10% tax on early distributions (see my April 5th blog, The 5-Year Freeze) and that there is a strong likelihood, although no guarantee, that the market will increase to at least the 11,000 level again within five years, IRS has created an out for you. You can make an election to reverse your Roth IRA conversion through a process called recharacterization.
Basically, you have until April 15th following the year of your conversion, or until October 15th if you applied, and were approved for, an extension of filing, to undo your Roth IRA conversion. You must transfer the amount of your Roth IRA conversion plus earnings thereon from your Roth IRA account back to your traditional IRA account via a trustee-to-trustee transfer by the applicable date.
Let’s suppose you do a recharacterization because the stock market has declined significantly since the date that you did your Roth IRA conversion and you want to do another Roth IRA conversion to potentially minimize your income tax liability attributable to your conversion while the market is still down. How long must you wait to do this? The amount of time that you must wait to do another Roth IRA conversion using the same traditional IRA depends on the timing of your recharacterization. If you do a Roth IRA conversion and recharacterization during the same year, you must wait until the following year to do another conversion. If, on the other hand, you do your recharacterization during the year following the year you did your conversion, you must wait 30 days following your recharacterization date to do another conversion.
As an example, suppose you did a Roth IRA conversion on April 12, 2010 when the market was above 11,000. The market continues to increase for a while and then it slides back below 10,000 at the end of 2010. Assuming that you file a 2010 income tax return extension application and your application is approved, you would have until October 17, 2011 (October 15th falls on a Saturday) to reverse your Roth IRA conversion through a recharacterization. Assuming that you don’t do a recharcterization in 2010, you file an extension application for filing your 2010 income tax returns, and you do a recharacterization by October 17, 2011, you would need to wait 30 days following the date of your recharacterization to do another conversion using the same traditional IRA account.
Through the magic of recharacterization, your Roth IRA conversion is insured until at least April 15th of the year following the year of your conversion in the event that the value of your Roth IRA decreases significantly from its value on the date of conversion. Like all insurance policies, beware of the exclusions, the most significant one being that your ability to recharacterize will end on April 15th of the year following the year of your conversion or October 15th if you have filed, and been approved for, an extension of time to file your income tax returns.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.