Edward A. Zurndorfer, Certified Financial Planner

In recent My Federal Retirement columns discussed how federal employees are eligible to contribute to Roth IRAs and are also eligible to convert traditional IRAs to Roth IRAs. In the case of a Roth IRA conversion, the Roth IRA owner may find that the conversion was a mistake. Federal income tax law provides for "undoing" the conversion, a process known as "recharacterization." This column discusses the recharacterization process.

As discussed in the Roth IRA conversion column, in most cases a traditional IRA owner will owe income tax on any pre-taxed components of the traditional IRA being converted. This includes pre-taxed contributions to the traditional IRA and all accrued earnings in the traditional IRA. Recharacterizing a Roth IRA conversion is beneficial if, after the conversion, the Roth IRA's value declines significantly. If the Roth IRA owner recharacterizes -- that is, "undoes" the Roth IRA conversion -- the owner will avoid paying taxes on the value of the traditional IRA on the conversion date that no longer exists. Consider the following example.

In February 2011, Jill, a federal employee, instructed the custodian of her traditional deductible IRA to transfer $40,000 to a new Roth IRA. Jill use pre-taxed dollars to contribute to her IRA and therefore has no cost basis in her traditional IRA; therefore, this conversion to a Roth IRA results in $40,000 of taxable income to Jill for 2011. In September 2011, the stock market falls and the value of Jill's Roth IRA (that was worth $40,000 when she converted it) drops to $25,000. To avoid paying tax on the $15,000 of value Jill no longer has, Jill elects to recharacterize her Roth IRA conversion. Using a "trustee-to-trustee" transfer, Jill moves the $25,000 in her Roth IRA to a traditional IRA on Oct. 3, 2011. Assuming Jill has met all the requirements to properly recharacterize the Roth IRA conversion, Jill's Roth IRA conversion is treated as if it never occurred. Jill will not have to include the $40,000 of income on her 2011 income tax return.

For a Roth IRA conversion, the deadline for recharacterizing the conversion is the due date of the tax return -including extensions - for the year the conversion was made. This deadline is automatically Oct. 15 if a tax return is filed by the preceding April 15 or if an filing extension is filed by Apr. 15. But the deadline is Apr. 15 if a tax return is not filed by Apr.15 and an extension due date was not filed.

Those individuals who performed Roth IRA conversions and who either filed their 2010 income taxes or requested an extension, the deadline for recharacterizing any Roth IRA conversion performed during 2010 is Oct. 17, 2011, the extended due date for filing 2010 income taxes.

How to Recharacterize

To recharacterize a Roth IRA to which the Roth IRA contribution or conversion, the contribution must be transferred from the "first" IRA (the one to which the Roth IRA was converted from a traditional IRA or the Roth IRA was converted from a traditional IRA) to the "second" (traditional) IRA in a "trustee-to-trustee" (direct) transfer (that means the Roth IRA owner cannot first take possession of the IRA funds and consequently send the Roth IRA funds to the traditional IRA). If the individual IRA owner properly elects to recharacterize, then the contribution is treated as if it was originally made to the second IRA instead of to the first IRA. Any earnings transferred from the first IRA to the second IRA are treated as if earned in the second IRA.

Individuals who recharacterize their contribution must perform all three of the following tasks:

· Instruct the Roth IRA custodian/trustee to transfer the contribution or converted amount, as well as any net income/accrued earnings allocated to the second (traditional) IRA. If there was a loss in value between the time the recharacterization was made or the traditional IRA was converted to a Roth IRA, then the net income transferred may be a negative amount.

· Report the recharacterization on their income tax return on IRS Form 8606 (see below) for the year which the contribution was made.

· Treat the contribution or conversion as having been made to the second IRA on the date that it was actually made to the first IRA.

Consider the following example:

On May 1, 2011, when her Roth IRA was worth $120,000, Alice made a $180,000 conversion contribution from a traditional IRA to the Roth IRA. On Oct. 3, 2011, Andy requests that the $180,000 be recharacterized to a traditional IRA. On Oct. 5, 2011, the date the Roth IRA trustee transfers the conversion contribution to a traditional IRA, the Roth IRA is worth $250,000. No other contributions have been made to Alice's Roth IRA and no distributions have been taken. The adjusted opening balance (for computing income attributable to the $180,000 conversion contribution) is $300,000 ($120,000 plus $180,000). The adjusted closing balance is $250,000. Thus the net loss allowable to the $180,000 contribution is a $30,000 loss ($180,000 x ($250,000 - $300,000)/$300,000. Therefore, to recharacterize the $180,000 conversion contribution that occurred on May 1, 2011, Alice's Roth IRA trustee must transfer $150,000 ($180,000 - $30,000) from Alice's Roth IRA to Alice's traditional IRA.

Reporting a Recharacterization

Individuals who elect to recharacterize a contribution to a Roth IRA as a contribution to a traditional IRA must report the recharacterization on their income tax return as directed by IRS Form 8606 and its instructions. To the extent a Roth IRA contribution is recharacterized, it is treated on the tax return as having been made to a traditional IRA. In addition, a statement that explains the recharacterization must be attached to the return for the year for which the original contribution was made.

When an individual recharacterizes a Roth IRA contribution, the Roth IRA trustee must report the amount contributed before the recharacterization as a contribution on IRS Form 5498 and the recharacterization as a distribution on IRS Form 1099-R. The Form 1099-R reporting the recharacterized amount as a distribution should show the following codes in Box 7.

• Code N if the contribution and recharacterization both required               .
• Code R if the contribution was made for 2010 but not recharacterized until 2011.

If an individual converts a traditional IRA to a Roth IRA and later recharacterizes the amount back to a traditional IRA, then none of the recharacterization is reported on Form 8606. But if only a part of the converted amount is recharacterized, then the amount not recharacterized (the part left in the Roth IRA) is reported on Form 8606.

When a Roth IRA is recharacterized, the nondeductible portion (representing any contribution to the Roth IRA) is recharacterized as a nondeductible traditional IRA contribution on Form 8606, Part I. If the recharacterization occurs in the same year as the contribution, then the amount transferred from the Roth IRA in total IRA distributions is reported on Form 1040, line 15a. If the recharacterization occurs in the year after the contribution, then the amount transferred is reported on an attached statement and not on a form of a tax return.

Rollover of the Thrift Savings Plan to Roth IRA

A retired federal employee who requests a one-time transfer of all or part of his or her Thrift Savings Plan (TSP) account to an existing rollover Roth IRA must report in income that amount being rolled over or transferred. The amount rolled over or transferred is fully taxable and must be reported on IRS Form 1040.

To summarize a Roth IRA recharacterization:

· The purpose of a Roth recharacterization is to undo all or a part of a Roth conversion and eliminate the income tax that would have been owed on the amount that was recharacterized.

· A Roth IRA conversion can be recharacterized for any reason;

· A partial recharacterization can be done;

· Roth IRA conversions may generally be recharacterized until Oct. 15 of the year the conversion was made. For Roth IRA conversions performed during 2010, the deadline is Oct. 17, 2011 (Oct. 15 is a Saturday).

· A Roth recharacterization can be performed only as a direct transfer of the funds from the Roth IRA back to at traditional IRA, not a withdrawal from the Roth IRA and a subsequent deposit to a traditional IRA. The funds go back to a traditional IRA even if the funds were originally converted from a company or government pension plan like a 401(k) plan or the TSP.

· The recharacterized funds can be transferred to the same IRA or to a different one.

· If the tax return for the year of the Roth IRA conversion already has been completed, a recharacterization can still be done by the Oct. 15 extended due date. That means any individual who performed a 2010 Roth IRA conversion has approximately one week (until Oct. 17, 2011) from now to recharacterize the conversion. The recharacterization will be reported on an amended tax return (assuming a 2010 income tax was previously filed) and the tax liability on the conversion will be eliminated.

Posted: 10/10/2011

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.

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