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Friday, November 13, 1998
Tax Q&A
Many of you have asked, "How may times can I convert, then un-convert, then re-convert my IRA to a Roth IRA, and vice-versa?" Until recently, that answer was not clear. Now it is. Because of the summer doldrums in the market, after a number of IRAs had been converted, many people decided to "un-convert" their Roth IRA back to a regular IRA and then "re-convert" back to a Roth IRA in order to save substantial tax dollars. Example: In June 1998, Tom converted his regular IRA #1 to a Roth IRA #1 when the value of his IRA portfolio was $60,000. Since Tom had no basis in his IRA, he was required to include $60,000 into his 1998 income (let's forget about the 4-year spread of income for the purposes of this example). But because of the summer market drop, Tom found the value of his portfolio reduced significantly� all the way down to $35,000. Because of this decrease, Tom faced the possibility of paying taxes on gains that he no longer had. Tom decided to "un-convert" (or, in tax lingo� recharacterize) his Roth IRA #1 back to a regular IRA #2. Then Tom took Regular IRA #2 and re-converted it to Roth IRA #2 when the value of his IRA portfolio was $35,000. Voila. Just like that, simply by moving these funds around, Tom saved tax dollars on the difference between his first conversion ($60,000) and his re-conversion ($35,000). Obviously, this could be a substantial tax-saving technique. Part of the problem here was that the original law did not contemplate this transaction. The recharacterization rules, which were put into place with the 1998 tax law changes, were meant to provide relief to those people who converted their Roth IRAs early in 1998, and subsequently found that their AGI would exceed the $100,000 limitation. The law didn't contemplate that some people would make these recharacterizations simply to save tax dollars. (Wow� how out of touch can the people in Washington really be?) But in a recent notice (AdvNotice 98-50, 1998-44 IRB), Uncle Sammy finally recognized that some individuals might just arrange their affairs in order to reduce their taxes (�duh) and addressed this very issue. Under this notice, a taxpayer who converts a regular IRA to a Roth IRA during 1998, and then shifts the amount back to a regular IRA using the recharacterization procedure, may re-convert the regular IRA back to a Roth IRA ONLY ONCE after October 31, 1998, and before January 1, 1999. In addition, the taxpayer is allowed only one re-conversion in 1999. If more than one re-conversion takes place during that time, they are considered "excess re-conversions" and are subject to special rules. But any re-conversions made before November 1, 1998 aren't treated as "excess re-conversions," no matter how many of them actually took place. Example: Let's look at a simple example and see how complicated this could actually be...
If this is the end of the transactions, everything is fine. No "excess re-conversions" here. But Roth IRA #2 may subsequently be recharacterized as regular IRA #3. The re-conversion of regular IRA #3 to Roth IRA #3 before January 1, 1999 would be an excess re-conversion, subject to the excess re-conversion limitations. If Roth IRA #2 is recharacterized as regular IRA #3, this regular IRA #3 can be re-converted to a Roth IRA once during 1999. Any additional re-conversion in 1999 would be an excess re-conversion. Excess Re-conversion: If you violate the excess re-conversion rules, you effectively ignore any of those conversions deemed "excess" for tax purposes. The taxable conversion amount would be based on the last re-conversion that wasn't considered an excess re-conversion. And even though an excess conversion will be ignored for tax purposes, it will still be treated as a valid Roth IRA conversion. You simply won't receive the benefit of a lower tax on the conversion. Example: Let's use the following facts and follow the results:
The December 8, 1998 transfer is deemed an ineligible re-conversion (since it's the second one after October 31, 1998) and is treated as an "excess re-conversion." While it is a valid conversion for Roth IRA purposes (that is, the Roth IRA is valid, and can remain open and in force), the portfolio value is not taken into account for tax purposes since it is an "excess re-conversion." This being the case, the taxable conversion amount is the November 25, 1998 re-conversion value of $30,000. Obviously, this assumes that the regular IRA has no basis (that is, the taxpayer didn't make any non-deductible contributions to the IRA). Additionally, since the conversion took place in 1998, the taxpayer has the option of recognizing the $30,000 conversion value as taxable income in 1998, or spreading that income out over a four-year period and recognizing $7,500 each year for the next four years. Moving on to next year, remember that if you convert a regular IRA to a Roth IRA in 1999 (that has not been previously converted), and then make a recharacterization back to a regular IRA, you may re-convert that account to a Roth IRA only once before year 2000. By implementing these rules, the back and forth conversion, un-conversion, and re-conversion process is effectively shut down for 1999. Finally, you should know that for determining whether a prior conversion has been made for purposes of this notice, a "failed" conversion is NOT treated as a conversion. A "failed" conversion is one for which the taxpayer is ineligible because modified AGI for the year exceeds $100,000. Simple? Nope. Easy? Not quite. Understandable? Hardly. All I can hope is that all of you who have played the "conversion" game with your IRA/Roth IRA now understand the rules. If not, you could be in for a very rude awakening come tax-filing time. If you want to read more about Roth IRA issues, you can check out my series of articles on that very issue in the Tax Article Archives. You should also make sure that you read about the 1998 tax law changes that took place recently that also had an impact on Roth IRA issues. Of course, if you have any additional questions on this entire issue (mess?), you can always post them in the Tax Strategies message folder.
Please note that Roy cannot answer individual questions via e-mail. If you have tax questions, please ask them on the taxes message board. Thanks!
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