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

Copyright  © 2009 My Federal Retirement.  All rights

reserved. This article may not be reproduced without express written consent of

My Federal Retirement.