Roth Recharacterizations: What Happens to Earnings or Losses?

It’s time to do those last recharacterizations for 2009 and file those last returns. October 15, 2010 is the deadline for both. YOU ONLY HAVE UNTIL FRIDAY FOR BOTH!

When you do a Roth recharacterization, your recharacterization request is for the amount of the original conversion that you want to undo. Then you do a net income calculation and come up with the actual amount that will be transferred back to the traditional IRA. (More details on this can be found in IRS Publication 590). The amount transferred back can be more than the original converted amount if there were gains in the Roth account or it can be less if there were losses in the Roth account.

Many taxpayers and their advisors then ask what happens to that gain or loss. The simple answer is: NOTHING. A Roth recharacterization is an undo. For tax purposes, the converted funds are treated as though they never left the IRA. So any gains or losses are treated as though they were earned inside the IRA. There is no loss you can deduct on your tax return and there is no gain to be taxed on the return.

But don’t forget to let IRS know that you have recharacterized your Roth conversion. A note must be attached to the tax return or to the amended return that gives IRS the date and amount of the conversion and the date and amount of the recharacterization. This should prevent any future communications from IRS asking for any taxes, interest, and/or penalties on the transactions.

Private Letter Ruling 201038019

"Jeff's" trust is the beneficiary of two IRAs at two different financial institutions. "Jeff's" three children are the beneficiaries of the trust. The trust does not limit the children’s access to the IRAs. A copy of the trust was given to each IRA custodian (i.e. financial institution) by October 31st of the year after "Jeff's" death. This allows the age of the oldest trust beneficiary to be used in calculating required minimum distributions (RMDs).

The three children propose to open six inherited IRAs, one for each child for each of the two IRAs. (2+2+2=simple math!) The IRAs will be in the name of "Jeff for benefit of the trust share for (insert respective child’s name)." The funds move trustee-to-trustee from "Jeff's" two IRAs to the six inherited IRAs. After that, the children will open six more inherited IRAs in the name of "Jeff for the benefit of (insert respective child’s name)." The IRA funds move via trustee-to-trustee transfers from the first six IRAs to the six IRAs for the benefit of each child.

What happens? The IRS granted all ruling requests, allowing the children to do what they proposed. The children end up with inherited IRAs in their own names that ignore the trust. They do NOT get to use their own life expectancies, but must use the life expectancy of the oldest child.

LESSONS TO LEARN:

1. The trust was unnecessary in this case and the children have to go through a lot of steps to get to an inherited IRA in their own names. "Jeff" could have simply named the children directly on the beneficiary form, in which case they could have used their own life expectancies. Instead, they had to pay the IRS fee of $10,000 for this ruling.

2. Financial institutions need to be more aware that these transactions can be done in instances where the trust allows unlimited access to the funds or in instances where the trust terminates. A distribution of the IRA out of the trust to the trust beneficiary need NOT be a taxable event if the funds are moved in a trustee-to-trustee transfer (no check is made payable to the trust) and the new inherited account title contains the name of the decedent and states that it is an inherited account.

3. It is important to make sure that the trust documentation requirement is met. Trustees of trusts where IRA owners died in 2009 only have until October 31, 2010 to provide a copy of the trust to the IRA custodian or plan administrator (or a list of the trust beneficiaries and their entitlement). Without this documentation, the distributions to the trust will be accelerated, which means taxes on those distributions will be due sooner and tax may be assessed at the higher trust tax rates.