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How to Get a “Do-Over” on Your Roth IRA - Nelson Securities, Inc.

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How to Get a “Do-Over” on Your Roth IRA
Investors who convert to Roth IRAs can change their minds and reverse the conversion through
a technique known as recharacterization.
by brian dobbis
ife doesn’t offer many opportunities for “do-overs.” Usually, we have to live with
the consequences of our decisions, even though we would have made different
ones, had we only known. But by taking advantage of a technique called
recharacterization, investors have a rare opportunity to undo a specific financial transaction if
it doesn’t unfold according to expectations. The opportunity occurs when investors convert
a traditional, SEP, or SIMPLE IRA to a Roth IRA. Here’s how it works.
Since 2010, all Americans who have a traditional IRA (SEP or
SIMPLE IRA) are able to convert all or part of their IRA to a
Roth IRA.1 This represents a unique opportunity, particularly
for those whose adjusted gross income (AGI)2 exceeds $100,000.
Prior to 2010, whether you were married or single, if your AGI
exceeded $100,000, you were not eligible to convert. Once a
Roth account has been established for at least five years and you
are at least 59ВЅ years old, all proceeds paid from the Roth IRA
are free of income taxes. In addition, no minimum distributions
at age 70ВЅ are required, as long as you or your spouse is still
alive, assuming your spouse is the first to inherit the account. If
someone other than a spouse inherits your account, minimum,
generally tax-free, distributions are required.3
So what’s the catch? Your IRA is subject to income tax in
the year in which the conversion takes place. Generally, you
are taxed on the converted amount that was not previously
taxed, such as deductible contributions to an IRA, or on the
balance in your current IRA that was rolled over from a prior
employer’s retirement plan. If you are one of the many Americans who are considering converting to a Roth IRA, you may
want to do it as early in the year as possible.4
Let’s look at a hypothetical situation: Chris chose to convert
a $100,000 traditional IRA to a Roth IRA on January 5, 2013.
The account appreciated and, by the end of the year, is worth
$130,000. The value would be the same whether he had converted or not, but had he waited to convert, there would have
been, theoretically, another $30,000 on which to pay taxes.
But, as we are painfully aware, investments do not always go
up. What if Chris completed the hypothetical conversion as
described above, but the investment plummeted 30% instead
of growing 30%? The value falls to $70,000. Chris initially has
lost money “on paper,” but he still owes taxes on the original
$100,000 converted. But as long as it is within the IRS prescribed time frame, Chris can choose to recharacterize the
Roth conversion back to a traditional IRA, thereby erasing the
conversion transaction and any tax liabilities that might have
otherwise occurred. In this example, Chris has until October
15, 2014, to recharacterize. Therefore, Chris has from January
5, 2013, until October 15, 2014, to evaluate investment
performance and decide whether to do nothing or to recharacterize. (October 15 represents the final tax-filing deadline
with extensions. Taxpayers can file an amended tax form any
time between April 15 and October 15 of the same year, and
will be refunded overpaid taxes, if any).
Should Chris recharacterize, the conversion never happened,
as far as the IRS is concerned.
Chris owes no taxes on the $100,000 conversion, and the
IRA is restored to the type of account (traditional IRA) it was
before any changes took place. The account balance, alas,
remains the same $70,000. But that presents an opportunity of
a different kind.
Chris now can reconvert (do the conversion again) the
remaining $70,000 to a Roth IRA and pay taxes on its value at
the time of that conversion. According to IRS rules, Chris
Timing Is Everything
IRS rules dictate when recharacterizations and reconversions can occur.
Roth IRA Conversion: converting a traditional IRA to a Roth IRA
Recharacterization: undoing the conversion and reverting to a
traditional IRA
As late as October 15 following the year of the conversion
Reconversion: converting again from a traditional IRA to a Roth IRA
The later of the calendar year following the initial conversion or more
than 30 days
must wait more than 30 days from the recharacterization date
or until the next calendar year, whichever is later, before he can
reconvert. He also could choose to recharacterize his IRA but
not reconvert.
when two might be better than one
Chris’s tax advantage could potentially become even better if
he decides at the time of the conversion to split the converted
Roth amounts into two or more IRAs instead of one.
Suppose Chris split his hypothetical $100,000 conversion
into separate $50,000 Roth accounts: one invested in the S&P
500В® Index5 and the other in the Barclays U.S. Aggregate Bond
Index.6 Now, let’s further suppose that in 2013 the indexes perform very differently, with the S&P index losing 37% and the
Barclays index gaining 5.2%, as they did in 2008. At the end of
our theoretical year of 2013, the Roth IRA invested in the S&P
500 would be worth $31,500 and the Roth IRA invested in the
Barclays U.S. Aggregate Bond Index would be worth $52,600,
for a total of $84,100 in IRA investments. Of course, this
example is hypothetical, and the market may fail to perform in
a similar manner under similar conditions in the future. It is
also important to note that an investor cannot invest directly in
an index and will not experience similar results.
When you recharacterize a Roth IRA, it is done on an IRAby-IRA basis. Since Chris split the hypothetical IRAs, he can
decide to recharacterize only the S&P 500 IRA as a traditional
IRA, and thus avoid having to pay taxes on the $18,500 paper
loss, while still retaining the opportunity to reconvert later at
the lower value. The second IRA could be left intact, and
Chris pays no additional taxes on the $2,600 gain in that fund.
On the other hand, if the Roth IRAs were not split but
instead were still allocated to the same two investments within
a single IRA, a decision to recharacterize would have caused
Chris to return the entire $84,100 account ($31,500 in the IRA
invested in the S&P 500 and $52,600 in the Barclays Aggregate
Bond Index) to a traditional IRA. Chris would realize a tax
savings on just $15,900 in this example, versus $18,500 had the
investments been split.
In order to have this flexibility, Chris may have to pay additional fees, which vary by investment firm. But, we ask: isn’t,
for example, an extra custodial fee worth the potential tax
savings on $2,600 in our case study? [This potential tax saving
does not take into account inflation, tax rate changes over
time, or any additional fees/costs.] And once the recharacterization period ends in this example (October 15, 2014), the
two Roth IRA accounts can be combined and the extra custodial account fee eliminated. However, combining accounts
may result in the assessment of transaction costs or other fees.
The rules of converting differ when it comes to in-plan
Roth rollovers, which were permanently expanded under the
American Taxpayer Relief Act of 2012. Consequently,
employees with eligible retirement plans (401(k),7 403(b),8 or
governmental 457(b)9 plans) can convert all vested pretax
assets to designated Roth accounts, generally at any time. As
with traditional IRA conversions, in-plan conversions are
subject to taxation in the year in which the conversion takes
place. But unlike with traditional conversions, in-plan Roth
conversions are irrevocable. Recharacterization is not permitted. So investors should carefully consider the possibilities
before committing to an in-plan conversion.
We recommend that you sit down with your financial
advisor as soon as possible this year and decide whether the
Roth conversion is right for you. You don’t have to convert
the whole amount in 2013. Some taxpayers may feel the tax
liability on the full value of their assets is too much. You can
convert your account in pieces, or not at all. (We also have a
useful calculator tool to help you determine whether a conversion makes sense. See “Should I Convert to a Roth IRA?”
located on our Retirement Calculators page in the Retirement
section of our website, Whatever you decide,
you’ll likely be better for the exercise. n
[The examples in this commentary are hypothetical and for
illustrative purposes only and do not represent the performance of any Lord Abbett product or specific investment. It is
intended to provide general education and is not intended to
serve as the primary or sole basis for your investment or taxplanning decisions. Please keep in mind that the hypothetical
values do not reflect the fees and charges associated with specific investment products. If included, results would be lower.
Please note that indexes are unmanaged, do not reflect the
deduction of fees or expenses, and are not available for direct
Brian Dobbis, QPFC, QPA, QKA, is a Lord Abbett Retirement Analyst—Private Wealth Group, and serves as the firm’s
IRA technical resource. He also manages Lord Abbett’s 403(b)
and 457 business channels. Mr. Dobbis began his career in the
financial services industry in 1996. He joined Lord Abbett in
2002, and held the positions of Retirement Consultant and
Retirement Research Associate. Mr. Dobbis is recognized by
the American Society of Pension Professionals and Actuaries
(ASPPA) as a Qualified Plan Financial Consultant (QPFC), a
Qualified 401(k) Administrator (QKA), and a Qualified Plan
Administrator (QPA). He earned a BA in communications
from Rowan University, and is a holder of the Series 6, Series
63, and Series 65 licenses.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59ВЅ, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but
withdrawals during retirement are generally tax-free.
Adjusted gross income (AGI) is a measure of income used to determine how much of your income is taxable. Adjusted gross income (AGI) is calculated as your gross income from taxable sources minus
allowable deductions, such as unreimbursed business expenses, medical expenses, alimony, and deductible retirement plan contributions.
Minimum distributions must be taken from traditional IRAs by April 1 following the year that a person turns 70ВЅ. A minimum distribution must be taken from the IRA in each subsequent year. Failure to
take the required minimum distribution will result in a 50% penalty on the amount that was not distributed. Mandatory distributions that represent deductible contributions and all earnings are taxed as
ordinary income. Mandatory distributions based on nondeductible contributions are tax-free.
The Tax Increase Prevention and Reconciliation Act eliminates income limits on conversions of traditional IRAs to Roth IRAs after 2009. If the conversion took place in 2010, income could be reported ratably in 2011 and 2012 on the amount converted. If the conversion takes place in 2012 or beyond, taxes on the taxable portion of the amount converted are due in the conversion year.
The S&P 500о‚Ё Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
The Barclays U.S. Aggregate Bond Index represents securities that are U.S. domestic, taxable, nonconvertible, and dollar-denominated. The index covers the investment-grade, fixed-rate bond market, with
index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
A 401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (reduction) contributions on a pretax or aftertax basis. Earnings accrue on a tax-deferred basis.
A 403(b) is a retirement plan for certain employees of public schools and tax-exempt organizations and certain ministers. Generally, retirement income accounts can invest in either annuities or mutual
funds. Also known as a tax-sheltered annuity (TA) plan.
A 457(b) is a nonqualified, deferred-compensation plan established by state and local governments, tax-exempt governments, and tax-exempt employers. Eligible employees are allowed to make salary deferral contributions to the 457 plan. Earnings grow on a tax-deferred basis, and contributions are not taxed until the assets are distributed from the plan.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income.
Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if
withdrawn prior to age 59ВЅ, unless an exception applies.
A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and
their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective
contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.
A simplified employee pension plan (SEP-IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible
employee’s SEP-IRA.
Keep in mind that investing involves risk, including the possible loss of principal. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views
of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a
particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. This document is prepared based on information
Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor
prior to making an investment decision.
Copyright В© 2013 by Lord, Abbett & Co. LLC/Lord Abbett Distributor LLC. All rights reserved.
Lord Abbett mutual fund shares are distributed by Lord Abbett Distributor LLC.
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