Edward A. Zurndorfer, CFP

During 2008, the stock market had its worst performance in decades. Many individuals who converted their traditional IRAs to Roth IRAs during 2008 saw their converted Roth IRAs drastically decline in value. Many of these individuals paid federal and state income taxes on converted Roth IRAs that are currently worth much less than they were before they were converted.

Consider this example. 

In January 2008, Roberta converted a $60,000 traditional IRA to a Roth IRA. During 2008, Roberta was in a 25 percent federal marginal tax bracket, resulting in a 25 percent of $60,000 or $15,000 tax bill. If Roberta's converted Roth IRA is currently worth $10,000, then she paid income tax on $60,000 of an account value that no longer exists. 

The Internal Revenue Code (IRC) provides a tax savings -- if not a tax elimination -- opportunity for Roberta and others who performed Roth IRA conversions during 2008. This opportunity allows individuals to "recharacterize" their Roth IRAs and eliminate the tax liability. A Roth recharacterization is the process by which a Roth conversion is undone and the assets in the converted Roth IRA are transferred back to a traditional IRA. 

Anyone - no matter their current income - is eligible to recharacterize an IRA for any reason. After the recharacterization, the funds are treated as if they were never transferred from the traditional IRA to a Roth IRA. 

The deadline for performing a recharacterization on converted traditional IRA funds to a Roth IRA during 2008 is October 15, 2009. The recharacterization must be done as a "trustee-to-trustee" transfer. 

The custodians of the Roth IRA (where the money is currently located) and the traditional IRA (where the recharacterized money will be transferred) must be notified in writing. While the custodians for both accounts may be the same institution, they are frequently different institutions. 

Included as part of the written notification must be the following information: 

• the dollar amount of the original conversion to a Roth IRA that is to be recharacterized. For example, Roberta in the above example would state $60,000 as the converted amount. 
• the date on which the retirement funds were converted to the Roth IRA;   
• instructions to the Roth IRA custodian to transfer the amount of the conversion and net income (or loss) allocable to the conversion. This is where the adjustment is made for the loss of value on the converted amount. The custodian should determine the gain or loss on the entire account balance and determine how much of the gain or loss is attributable to the conversion amount being recharacterized. 
• the names of the Roth IRA and the traditional IRA custodians. 

If an individual performed a Roth IRA conversion during 2008 and has not filed his or her 2008 federal income taxes, then the recharacterization will be reported on IRS Form 8606 and included as part of the 2008 federal income tax return. 

If the 2008 federal income tax return has been filed and a recharacterization was completed before the Oct. 15, 2009 deadline, then an amended 2008 federal income tax return will have to be filed via Form 1040X. "Filed pursuant to Section 301.9100-21 (b) must be written on top of page one of Form 1040X. The amended return should be mailed to the same address as the original return was mailed. The amended return must be filed within three years of the original due date or extended due date of the original return. The amended return will result in a refund to the IRA owner if taxes were paid as a result of the Roth IRA conversion during 2008. 

Some other important information and facts about IRA recharacterization and Roth IRA reconversions: 

• Losses incurred due to a recharacterization are not deductible as they are deemed to have occurred within the Roth IRA. 
• Recharacterizations and reconversions distributions are reported by the IRA custodians on Form 1099-R, Box 7, code "N" or "R." Recharacterization will be reported on Form 5498 in the box titled "Recharacterized contributions." 
• The election to recharacterize a contribution may be made on behalf of a deceased IRA owner by his or her Executor, Personal Representative, or other person responsible for filing the return. 
• Recharacterizations are irrevocable and are not treated as a rollover for the purpose of the rollover per year limitation. 
• Conversions that are recharacterized may not be reconverted until the later of the beginning of the tax year after the year of conversion, or the end of thirty days after the recharacterization.

Here is an example. 

George converted a traditional IRA into a Roth IRA in April 2008 when the account was valued at $62,000. By February 2009 the account had dropped to a value of $24,000. On Feb. 28, 2009 George invalidates the conversion by recharacterization. George will have to wait until Jan. 1, 2010 to convert the funds back to a Roth IRA. In this case, the beginning of the year after conversion (Jan. 1, 2010) is later than 30 days after the recharacterization (March 29, 2009).  

Finally, if a reconversion does not meet the above mentioned rules, the reconversion will be treated as a failed conversion, subject to corrections through recharacterization back to a traditional IRA. This will result a distribution from the traditional IRA that is subject to federal and state income taxes and possibly a penalty.

About the Author 

Edward A. Zurndorfer is a Certified Financial Planner and Enrolled Agent in Silver Spring, Maryland. He is also a registered representative with Multi-Financial Securities Corporation (Branch A9X), member FINRA/SIPC, also located in Silver Spring, Maryland

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