“Year of the Conversion,” the initial post on January 11th of this year kicked off a weekly series of informative posts regarding a tax/financial planning technique that was authorized by Congress beginning in 1998. As explained in “Year of the Conversion,” from 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. Beginning in 2010, the $100,000 income threshold has been eliminated and, as a result, anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.
I felt it would be fitting to conclude the Roth IRA conversion series with “Year of the Extension” to remind anyone who has done a conversion in 2010 or is still planning on doing one in 2010 or in future years of a very important, and often overlooked, step in the Roth IRA conversion process. Unlike most tax planning techniques whereby once you’ve implemented the technique, it’s a done deal and you simply need to report the historical transaction on your income tax return, Roth IRA conversions need to be monitored for up to 22 months following the conversion date depending upon when the conversion occurs.
Given the fact that (1) the amount of income that you’re required to report on your income tax return is based on the value of the portion of your traditional IRA that you convert on the day of the conversion and (2) there exists the possibility that there can be a decline in value following the conversion, IRS has provided us with an insurance policy for this situation. Through a process referred to as recharacterization, you’re provided with a window of opportunity to undo your Roth IRA conversion and the associated income that you’re otherwise required to report on your tax return.
The April 19th post, “Recharacterization – Your Roth IRA Conversion Insurance Policy,” explains this technique, including the amount of time that must pass before you can do another Roth IRA conversion. Basically, as explained in the post, you have until April 15th following the year of your conversion, or until October 15th if you applied, and are approved, for an extension, to undo your Roth IRA conversion.
In order to minimize the income tax liability associated with your conversion, you need to monitor the value of your Roth IRA following the date of your conversion through April 15th following the year of your conversion to determine if you should recharacterize your conversion. Furthermore, if you haven’t done a recharacterization by April 15th of the year following the year of your conversion, it’s highly advisable to apply for an extension of time to file your income tax return. By doing this, you will extend your potential recharacterization timeframe by an additional six months until October 15th.
It’s important to keep in mind as always whenever you file an extension that 100% of your income tax liability must be paid by April 15th since an extension is only an extension of time for filing your return. It doesn’t extend the time for payment of your tax liability.
Unless you’re fortunate to either have enough basis in your traditional IRA or losses and/or deductions to offset the income attributable to your Roth IRA conversion so that you will incur minimal or no income tax liability attributable to your Roth IRA conversion, you need to monitor the value of your converted Roth IRA until at least April 15th following the year of your conversion and possibly for an additional six months until October 15th. If you’re in this situation, always remember to file an extension application by April 15th following the year of your conversion.
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.