by Robert Daigle, CFP®, CLU®, CTFA®
Robert Daigle is a lead planner specialist with USAA in San Antonio, Texas, assigned to the Trust Department. He joined the profession in 1992 with Shearson Lehman Brothers, moved to Prudential Securities in 1995, and joined USAA in 2004 as a financial planner. He became one of USAA's first wealth managers in 2008. Before being assigned to the Trust Department, he focused on making USAA advisers proficient in advising its members on converting traditional IRA accounts to Roth IRA accounts.
Executive Summary
- This article is narrowly focused on the timing and implications of re-characterizing a former conversion of a traditional IRA to a Roth IRA and a subsequent conversion to a Roth account of the same assets.
- It explains the rules of both re-characterizing and converting again.
- More importantly, it describes the disadvantage of re-characterizing before necessary, and defines the precise and non-intuitive timing of the complete process.
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Most of us expect there will be higher tax rates after 2010. And, as we will show here, any re-characterization cannot be converted again before January 1, 2011. For those clients who intended for all of the income from the original conversion to be included at 2010 tax rates, re-characterizing and converting again would instead cause the income to be taxed at 2011 rates, whatever those might be. Additionally, re-characterization would eliminate the "one time" opportunity to split the income from conversion over 2011 and 2012. One should ask their tax advisers to analyze the tax consequences before making the decision to recharacterize and convert again. |
At the first of this year, most of us became eligible to move assets from a traditional IRA over to a Roth IRA. There were many reasons one would choose to do so, but in every case this maneuver was undertaken with the knowledge that such action would trigger additional income for this year. Most of those who did so also understood that there was some period of time in which we could "undo" the conversion if we chose to. While there could be several reasons to initiate this re-characterization, this article pertains to only one: the rational decision to convert again at a more advantageous time.
Re-characterization and converting again are integral parts of a single process, and for most cases the one should not be done without the other. If the conversion initially made sense, then converting again after a re-characterization should make even more sense.
However, it is becoming apparent that most account owners do not understand the rules of the process, and many advisers do not understand the dynamics. Without such understanding it is likely that we are giving bad advice. In all cases this process will still result in a Roth account, one in which all future gains would be income tax free. However, the two parts of the process should be coordinated for maximum efficiency. The timing is surprisingly precise and not very intuitive. Once understood, advice can be given that would separate that adviser from those who do not understand.
Understand the Rules
For the sake of easier understanding, assume that this discussion applies to your own Roth IRA, and that you will follow the same advice you will be giving your client. The first step is to know and understand the rules. Your clients almost certainly do not.
- Re-characterization can take place any time before the final income tax deadline for the tax year of the conversion. For those to whom this article applies, that deadline is October 15, 2011.
- Converting again cannot take place during the same tax year of the original conversion. For us, regardless of when re-characterization takes place, one cannot convert again before January 1, 2011.
- Additionally, converting again cannot take place until more than 30 days have elapsed since the date of re-characterization.
The 30-day requirement functions like the "wash rule," with which we are all familiar. It is a roadblock that prevents us from doing the very thing we would all most like to do: re-characterize at what we expect to be the "bottom of the market" and then immediately convert again to take advantage of the lowest valuations. If these rules were not in force, the only task we would have would be to pick the bottom and save a bundle on taxes. We would have until October 15, 2011 to do so. The rules do exist, however, and it is essential that advisers understand their dynamics if we are going to give the best advice. Since we are bound by this wash rule and the ideal (simultaneous re-characterization and conversion again) cannot be done, it follows that the next best thing would be to convert again as soon as we can after re-characterization.
Park this realization for a minute while you consider another essential idea:
Re-characterization and converting again for income tax savings helps only if the market has receded. While the process we are describing here could be a good tool, we would never use it if the market went up after conversion. Are not tax free gains the reason we converted? Market gains occurring after we re-characterized are not beneficial if they happen before we convert again, and in fact would make converting again more expensive. On the other hand, any market decline before converting again, whether before re-characterization or after, would result in lower valuations upon converting again and less taxable income from the conversion.
Putting It All Together
We can now combine this realization with the one that we parked earlier:
Anyone who is going to re-characterize is harmed if the market advances after re-characterization, but helped if the market declines, any time before converting again. And, since we cannot predict the market, we want to be out of a Roth account the fewest possible number of days. This cannot be less than 31 days.
In light of these realizations, the only conclusion can be: In order to maximize any potential benefit of re-characterizing and converting again, one should re-characterize only on December 1. This would be the only date that would allow being out of a Roth the fewest possible days, 31 days under the wash rule. Thirty-one days from December 1 is January 1, which also is the earliest day we are able to convert again under rule No. 2. Minimizing the time between re-characterization and converting again minimizes the consequences to us of a market that advances during that time, but still allows us to benefit from market declines.
Market timers could rationalize that the December 1 date is valid, but that conversion again on January 1 is not essential. If they can accurately predict the market, they would be correct. However, for those of us who cannot do so, it is clear that conversion again on January 1 allows the highest probability for success in the absence of such ability to predict the future.
Conversion again on January 1 can only be accomplished if re-characterization occurred no later than December 1of the preceding year.
Summarizing, I suggest you need to make clients who are considering re-characterizing and then converting again aware of these points and that you should be prepared to explain them:
- Neither of us can predict the future direction of the markets with any amount of certainty.
- After one re-characterizes, converting again should be completed as soon as possible: January 1, 2011. This cannot be done unless one re-characterizes by December 1, 2010.
- You will have the maximum amount of information to help with the re-characterization decision if you wait until December 1. There are no drawbacks to doing so.
- Do not make the decision to re-characterize and convert again without discussing with your tax adviser the effect of anticipated tax rate increases in the near future.
Conversions from a traditional IRA to a Roth are subject to ordinary income taxes. Please consult with a tax adviser regarding your particular situation.
