Recharacterize Underwater Roth IRA Conversions

Did you have clients perform an IRA conversion to a Roth IRA last year?  If so, I’m willing to bet that the value of the account when the conversion took place is a bit higher than it is now.  There may still be time to undo the conversion and potentially save clients money.

A quick review on conversions: Taxpayers (other than married filing separately) with a Modified AGI of $100,000 or less may convert assets in an IRA (including a SEP or SIMPLE after 2 years of participation) to a Roth IRA. Taxpayers owe ordinary income taxes on the amount converted, but not the 10% premature distribution penalty.

Conversion Example

Let’s say your eligible client converted a Traditional IRA worth $50,000 during 2007 to a Roth IRA.  This conversion triggered an additional tax of $12,500 assuming the taxpayer was in the 25% tax bracket.  Unfortunately for your client, the conversion was performed at the peak of the stock market.  We’re down in the neighborhood of 30 to 40 percent from those highs, so that $50,000 once converted might only be worth $30,000 today.

This means your client has paid income taxes on phantom income of $20,000, resulting in $5,000 of “unnecessary” taxes paid.

Recharacterization

Fortunately, the IRS allows conversions to be undone through the process of recharacterization.  If the original conversion is recharacterized, then it is not reported and there is no income tax due.

Act Now!

There is a deadline to report recharacterizations.  This deadline is six months after the due date of the of the 2007 tax return.  In other words, a recharacterization of a 2007 conversion needs to be communicated to the plan sponsor by October 15, 2008, so time is of the essence.

More Information

Publication 590 on the IRS website has more information on the recharacterization process, and it also includes details on provisions prohibiting a reconversion within a certain timeframe.  Read it for more information if some of your clients might take advantage of this opportunity.

This process doesn’t make sense for everyone, so it’s important to consider all the moving parts of each client’s particular situation.  For instance, if a taxpayer was in the 15% tax bracket for the original conversion in 2007, but will be in the 25% tax bracket for 2008 (or beyond), a 40% drop in the IRA account value basically means the taxes paid are a wash ($7,500 in both cases).

But if all things remain equal with a client, the recharacterization strategy may save clients thousands in taxes owed.