Recharacterize - dollars or shares?

[Guest Daniel Shedd]

I am getting confusing information from different brokers regarding the basis for recharacterizations and was hoping someone here might help.

Fidelity tells me that when I recharacterize assets, I do it 'in kind', so if I convert shares from a Roll Over IRA Brokerage account to a Roth brokerage acct early in the tax year, and later want to recharacterize all of my conversions for that year, I recharacterize the same number of shares, irrespective of dollar value.

Vanguard on the other hand says I need to recharacterize dollars, not shares, and that if the assest declines in value, I must recharacterize other Roth assests (if they exist) to 'undo' the tax liabilities of the earlier conversion.

Now Vanguard's position makes no sense to me (not that it or tax code has to make sense). I would have thought that the purpose of recharacterizing is to reverse an earlier transaction, in otherwords to go back to the original 'state', and that would require share conversion. Also, if Vanguard was right, then technically an investor could be left with a tax liability just for converting and then recharacterizing the same asset in the same tax year.

This is the scenario that confuses me. If a tax payer had only one asset, say 100 shares of a stock invested in a roll over IRA brokerage acct, and converted it early in the tax year, watched the asset decline in value, and then subsequently decides to recharacterise the same asset to avoid paying taxes on the conversion. Under Vanguard's logic, the asset would not be worth fewer dollars, and the investor would be unable to 'undo' or recharacterize the same dollar amount. So at tax filing time, the investor would be stuck paying extra taxes becuase the amount he converted was greater than the dollar amount he recharacterised.

Now I imagined that recharacterising in a down market was beneficial, ie result in fewer taxes not more.

I would love to hear from anyone who could shed some light on this. I have read the IRS pubs and can't recall anything which clarified this question, most of the explanations center around eligibility for conversions/contributions.

Thanks

Dan Shedd

[Appleby]

Neither of the responses are correct.

This is how it work- I will list two scenarios, full account and partial account transactions.

1. Full Account.

This is where you converted assets to a Roth IRA, which had no other assets in the Roth prior to the conversion. You now decide that you want to reverse (recharacterize) the conversion.

You made no contributions or distributions in the Roth IRA.

You will recharacterize the entire balance of assets in the Roth IRA. It does not matter if you still own the same assets you converted (i.e. you conducted various trades).

2 Partial account

You had some assets in a Roth IRA from previous contributions and conversions (from last year)

Earlier this year, you converted 100 shares of XYX stock to the Roth IRA.

You now decide that you want to recharacterize the conversion done earlier this year. You must do the following:

Perform a calculation to determine the current value of the conversion done this year. TO do so, you cannot look just at the performance of XYZ stock, but must take into consideration the performance of the entire account. This means that XYZ stock may have lost value, but based on the performance of other stocks, you may need to recharacterize a value higher than what you converted. ( or vice versa)

Once you determine the value of the conversion, you recharacterize that amount to the traditional IRA. This recharacterization does not have to be of XYZ stock, it could be cash, any other stock/s XYZ stock, or a combination thereof. As long as the assets that are recharacterized equal to the current value of the conversion ( i.e. the value determined when you take into account the performance of the entire account during the determination period) . Makes sense…

The attached document explains how the calculation must be done.

[BPickerCPA]

Appleby is correct.

[Guest Daniel Shedd]

Thanks fo much for the response. I will examine this document.

My problem involved partial conversions. Luckily the investment is in one stock only (not entirely true, but bulk of money is one stock, and the others in the Roth account fared even worse)

Dan

[Guest Daniel Shedd]

I had another question. Is the net income ever reported by the custodian on a 1099 R? I can't recall seeing anything like this, so I am not sure how the IRS knows how to reconcile this with tax returns?

[Guest Daniel Shedd]

Okay I looked at the IRS pub and still have more questions (if you would be so kind to entertain them).

The IRS pub had the following formula;

Adjusted Closing - Adjusted Opening

Balance Balance

Net Income = Contribution x _____________________________________

Adjusted Opening Balance

I am assuming that "Contribution" refers to conversion amount. So, if I started the year with everything in a traditional IRA (for arguments sake $10,000) then converted to a Roth, watch the account value drop to $5,000, recharacterised all of the orignial conversions shares (or now $5,000), what is my income? According to the forumla, would it be;

net income=$10,000*($5,000-$10,000)/($10,000)=-$5000?

??

I would have thought that the net income should be zero, if one were to 'undo' a conversoin in total. or do I had this to the amount of the original conversion of $10,000 to arrive at the amount of taxable income? if that was the case, I would have a tax liability just for moving money one way and then back again, which seems unfair.

Thanks

Dan

[BPickerCPA]

Daniel,

The reason you compute the income is to determine the amount to recharacterize, not to compute taxable income. When you recharacterize, you need to include the income.

In your example, you converted $10,000. The income is now a negative $5,000. Therefore you need to recharacterize $5,000 ($10,000 minus the $5,000 of negative income), in order to eliminate the $10,000 conversion. Of course, in a case where you convert into a new account, and recharacterize the entire account back to a traditional IRA, you cancel the entire conversion.

[Guest Daniel Shedd]

Now that I have a better understanding of the process, I wanted to pose a little more complicated scenario, one that more closely mirrors my own predicament.

Suppose on Jan 1 2000 I have $20,000 in a traditional IRA and shortly thereafter convert $10,000 of that to a Roth. A year later in Jan 2001 I convert the remaining portion ($10,000) of the traditional IRA to a Roth (same account). Then due to market conditions, the investment loses value and I want to undo or recharacterize both conversions, since according to what I have read here (assuming I didn't misconstrue the info) and at IRS web site, I had until Oct 15 of 2001 to recharacterize the year 2000 conversion.

Now according to the pub 2000-39, I have to take into account the value of the entire account when rechacterizing. Now when I try to recharacterise the 2000 conversion, the account has lost value due to market conditions, but it has also risen since additional funds entered the account due the year 2001 conversion.

Assuming for arguments sake the shares lost 50% value and that there was now$10,000 total in the account (half of $20,000) just before any of the recharacterizations, next I make two separate recharacterizations, one for each of the two conversions.

now if I wanted to rechacterize the year 2000 conversion , here's what I calculate for the income;

income=contribution*(adjusted closing balance-adjusted opening balance)/(adjusted opening balance)

now the contribution is $10,000, the adjusted closing balance would be $10,000 (since it now includes the 2001 conversion), the opening balance would have been $10,000, my net income is now $10,000*(0) or $0. so I would have to rechaacterize $10,000?! How would I then recharacterise the year 2001 conversion?

I know I must be confused with the mechanics of this, so please forgive the uninformed nature of my questions.

TIA

dan