The New Use of the Recharacterization Option for IRA Conversions: Will Sophisticated Roth IRA Planning Be Exploited?

Built on the foundation of the Tax Management Portfolios™, Bloomberg Tax is a comprehensive tax research solution designed by tax practitioners for tax practitioners.

By Prof. Kathryn J. Kennedy  

The John Marshall Law School, Chicago, IL

A new set of IRA rules is causing a stir among the benefits and financial communities. Beginning in 2011, there are no longer any income restrictions for taxpayers wishing to do a Roth IRA conversion from a traditional IRA; thus, the wealthy can now pursue a Roth IRA conversion. While the conversion to a Roth IRA from a traditional IRA causes immediate taxation of the IRA, all subsequent distributions from the Roth IRA are currently exempt from federal taxation. Many wealthy taxpayers understand the tax advantages of doing the conversion (as the income growth under the Roth IRA will be exempt from taxation), but balk at the payment of the upfront taxes due upon the Roth conversion, especially if the IRA account is sizable.

If a taxpayer does convert, the Code provides the taxpayer with the ability to "recharacterize" – meaning, a later changing of the taxpayer's mindset to treat the Roth IRA as a traditional IRA. Why would one consider that? The taxpayer may elect to initially convert the traditional IRA to a Roth IRA assuming that the IRA increases in value before the taxes are due, but then decide to have the Roth IRA "recharacterized" back to a traditional IRA if the IRA assets decline in value. The value of the Roth IRA conversion is that increased income escaped future taxation; however, a decrease in the value of the Roth IRA account balance produces no tax value and thus, the taxpayer would be better off under the traditional IRA treatment. Generally any recharacterization must be accomplished by the due date (including extensions) of the taxable year in which the conversion was made. Thus, a 2011 Roth conversion could be reversed as late as October 15, 2012, by a taxpayer who receives an extension of six months from his/her ordinary filing due date. If the taxpayer petitions for an extension to recharacterize, the IRS may extend the period at its discretion. This time gap presents a major planning strategy for wealthy IRA owners.

Some financial planners have suggested separating the converted Roth IRA into multiple accounts, each having different investment strategies. Those that increase in value remain as a Roth IRA, but those that decrease in value will be recharacterized back to the traditional IRA. But, this strategy opens up the possible for abuse of this recharacterization option. Two recently published articles highlight this potential:

  •   The Valuation of Strategic Use of the Recharacterization Option for Traditional to Roth IRA Conversions, by David Stowe, Andy Fodor, and John Stowe. This article discusses option pricing models to determine the value of the recharacterization option so as to maximize the use of such value; and
  •   High Volatility, Negative Correlation, Roth IRA Conversions, and the Codified Economic Substance Doctrine, by Gregg Polsky. This article discusses the strategy of having the taxpayer purchase derivatives to reduce the tax payment to the IRS as a result of the conversion.

The second article's author, Gregg Polsky, notes that the Investment Company Institute quotes a potential $4 trillion in non-Roth IRAs as of the end of 2009, with another $4 trillion in employer-provided defined contribution plans that could eventually be rolled-over into IRAs. Such large values illustrate the potential for abuse on a wide-scale basis.

The ability to permit the "unwinding" of an IRA conversion based on hindsight was certainly not the intent behind the original legislation. If such abuse does occur, there are numerous suggested solutions that will involve legislation remedies, including: tightening up of the deadline; requiring the recharacterization of the entire Roth IRA; or limiting the number of recharacterizations a taxpayer may make in a given tax year. Alternatively, there are currently available regulatory solutions that the IRS could use, including the economic substance doctrine. In either scenario, though, Congress and the IRS will be slow in responding to the potential for such abuse.

 For more information, in the Tax Management Portfolios, see Kennedy, 367 T.M., IRAs,  and in Tax Practice Series, see ¶5610, IRAs. 

Request Bloomberg BNA Tax & Accounting