What do I do if I had to recharacterize my Roth IRA back to a traditio

[Guest M Irby]

I converted my traditional IRA to a Roth IRA last October 2000. Soon after, I discovered that the income limitation for a conversion is different from the income limitation for contributions. Because I was afraid of exceeding the income limitation, I recharacterized back to a traditional IRA. However, the taxes had already been taken out for it! Now I'm trying to prepare taxes for 2000, and don't know what to do... I am going to be able to convert to the Roth IRA in 2001 with no problems, but do I have to pay taxes again? Will I be penalized for this? Please help!

[BPickerCPA]

Your question is confusing. Why did you pay tax on the conversion if you recharacterized? I suspect you may mean that you had withholding on the conversion. That could be a problem because the amount withheld does not constitute part of the conversion and is considered income and subject to early withdrawal penalty.

You would get credit for the tax withheld.

Please clarify.

[Guest M Irby]

We didn't want to recharacterize back to a traditional IRA. We had to because of the income limitation on conversions. However, they had already withheld the 28% taxes from the original converstion to the Roth IRA. When we recharacterized back to the traditional IRA, that money was gone already. I hope this makes it more clear.

[BPickerCPA]

One should never have withholding on a roth conversion. If you had 28% withholding, then you only converted 72% of the IRA to the Roth. The balance was a regular distribution.

EXAMPLE: An IRA worth $100,000 is converted, with 28% withheld. In fact, the conversion is $72,000 and $28,000 is a regular distribution. You now recharacterize the $72,000. You are still taxed on $28,000, it is subject to the 10% early withdrawal tax, and that amount is now totally lost from `your retirement account. You have a credit of $28,000 on your return, which will more than cover the tax, but the real loss is in the future compounding of that amount.

[Guest M Irby]

So is there any way we can correct this? We obviously were not told this by the people we hold the IRA with. Can we correct the amount recharacterized back by paying the difference out of pocket? And when we convert again this year, do we have to pay taxes again? What should we have done? Should we have waited until now to pay the taxes? I appreciate your insight.

[BPickerCPA]

You can't be paying tax on the same money twice, because once the money is out of the IRA, it's out of the IRA.

EXAMPLE (to continue): You had $100K, $72K went to the Roth and $28K went to the IRS as withholding. Your conversion is only $72K and your recharacterization is deemed to be $72K. The $28K is out of the IRA and cannot now be replaced. You are taxed on the $28K. If you now convert the $72K (or whatever value it has now become), that is what you will be now be taxed on.

[John G]

Barry,

This is just another example of why people should seek professional support before converting, recharacterizing and rolling over. Some of the examples we have seen reported here involve "house size" assets. Just as you should not buy or sell a home without legal advice (to sing a Bruce Williams song) absolutely no one should undertake major actions involving IRAs, pension funds, Keoghs, etc. without discussing it with an accountant, tax advisor or financial planner.

In this example, the negative impact was huge compared to perhaps two hours of professional help. Arguably a 100:1 ration of impact to pro fees.

I am talking not just about major misunderstanding about tax withholding but also subtle issues of strategy and timing. Let the professional play the role of devils advocate and show you the non-rosey scenarios.

Get professional assistance!

{I am not in the accounting/tax service business and my viewpoint is purely based upon experience with ideas that turned sour when folks did not understand the rule.}

[BPickerCPA]

John,

I've said it before.

There is nothing more frustrating than telling someone who comes for a tax return, or with a tax question, that there is nothing you can do NOW, but if they had come to you at the time you could have helped immensely.

But such is life.

Barry