Recharacterization Blues

This page describes a particular problem that could arise when using the recharacterization rules to undo a Roth conversion. The 2017 tax law prevents this use of the recharacterization rules for post 2017 conversions.

One of the beautiful things about Roth IRAs is the ability to undo a conversion. Using a transaction called arecharacterization, you can get back to the same place you would have been if you never did the conversion in the first place.

Or can you? Depending on how their accounts were set up, some people who who use a recharacterization to undo a conversions don’t get the results they expect.

Adjusting for investment performance

The problem has to do with the method used to calculate the amount you have to return from the Roth to a traditional IRA when you undo a conversion. The original conversion amount has to be adjusted for investment performance that occurred during the period the money was in the Roth IRA. There’s no problem if your conversion went into a new Roth IRA created for this purpose. In that case, when you undo the conversion you’ll simply move the entire contents of the Roth back to a traditional IRA.

You’re allowed to put your conversion money into an existing Roth IRA, though, and many people do this. In that case, the IRS says you have to do the calculation based on the performance of the entire IRA, not just the particular assets that represent your conversion.

Example

Suppose you converted $100,000 into an existing Roth IRA last year, and now you want to undo the conversion. If the Roth IRA that held this money lost 20% of its value between the date of the conversion and the date of the recharacterization, you would have to move $80,000 back to a traditional IRA.

Why is that a problem? Let me add some more facts. At the time of the conversion you already had $100,000 in the Roth IRA, and that amount was conservatively invested. In the conversion you moved $100,000 worth of a riskier stock or mutual fund investment from your traditional IRA to the Roth. Following the conversion, the old investments managed to break even, while the new one lost 40% of its value.

Overall, the Roth went from $200,000 immediately after the conversion to $160,000 at the time you want to undo the conversion. That’s a loss of 20%, and as we saw earlier, you would have to move $80,000 back to the traditional IRA to undo the $100,000 conversion. But that means moving the investment you moved to the Roth (now worth $60,000) plus $20,000 from the investments that were already in the Roth before you did the conversion.

Outrageous result?

To many people this result seems outrageous. The money that was in the Roth before you did the conversion was all after-tax. Now you’re being forced to move $20,000 of that money back to a traditional IRA (if you want to undo the conversion), and that means you’ll eventually pay tax on that $20,000 again, when you take it out of the traditional IRA.

The Treasury was aware of this issue when it wrote the regulations for the earnings calculation. They felt a rule that looked at the investment performance of particular assets within the IRA would create too many problems. In explaining the regulation, they said:

Once contributions are commingled in an account, those dollars are no longer associated with particular assets or contributions. In the absence of maintaining separate accounts, tying particular assets to a particular contribution would create administrative problems for taxpayers, IRA providers and the IRS.

The Treasury’s position creates harsh results in the situation described above, but people are generally free to change their investments any time they choose, and a rule that allowed or required people to trace the conversion assets through a series of changes would indeed be difficult to apply. Furthermore, the Treasury provided a way to avoid this result: use a separate Roth IRA for the conversion money, at least until you’re past the end of the period in which a recharacterization is possible. You’d have to contend with more paperwork and perhaps additional fees, but that could be a small price to pay to avoid this result.

One more point: the Treasury’s rule can work for you rather than against you. Your investment results could be the reverse of those described above, with the older investments in the Roth IRA declining 40% and the new one breaking even. In that case you would still be able to undo the conversion (and eliminate $100,000 of income from your tax return) by moving $80,000 from the Roth to a traditional IRA, even though your conversion investment never lost any value.

Conclusions

If the investments for your conversion money are the same as or similar to the investments you already have in your Roth IRA, it probably doesn’t make sense to create a separate Roth IRA for the conversion. If you have different types of investments, though, it may make sense to put the conversion money in a separate Roth and use that account for your more aggressive investments. That way you maximize your potential tax benefit from a recharacterization in the event those investments perform poorly after the conversion.