converting and rechar’ing strategy

Submitted by Newt Pearson on Mon, 2009-12-21 21:45

Hello

I have read Rechar. Blues on Fairmark and a few other short articles but I want to be sure about a slight variation.

Strategy—Convert 50% of an amt in M.M. and the remaining 50% in stock to roth . This would represent twice as much as I will eventually
keep converted . By deadline next year rechar. all of the m.m. if stocks go up or rechar all of the stock if they go down . Each of the 2 will be held in separate
accounts neither of which hold roth assets .

Questions

1. Can this strategy of rechar 100% of 1 or 100% of the other be done?

2. Doesn’t this eliminate those steps of calculation ?

3.Would there be any difference/advantages in both pieces being my money or my wives versus 1 piece being mine and the other being my wives ? Other than I wouldn’t
know at conversion which spouses piece would be rechar next year .

4. I’m I overlooking something in this strategy ?

Thanks



Submitted by Alan Spross on Mon, 2009-12-21 22:22

1) Sure, this is doable and not limited to 100%. You could change to 100% to any other percentage you wanted to and a different percentage for each.

2) Yes, converting into different Roth accounts is essential here. There is no complex earnings calculation for recharacterization. For 100% the entire balance of that account is recharacterized. For 50%, just multiply the value by 50%.

3) There is an advantage in converting the spouse’s IRA that has the highest % of basis first if either has basis from Form 8606. There is no pure recharacterization advantage either way, but there can be a tax advantage because for 2010 conversions only, one spouse can make a different deferral election than the other spouse, and that permits use of the 2010 marginal tax bracket for the spouse that opts out of the two year deferral. Otherwise, there is no advantage strictly from a conversion/recharacterization strategy.

4) Nothing major. Just be prepared to properly report the conversion and recharacterization and be aware of reconversion time limitations and future tax rate changes. For example, if tax rates rise in 2011 and 2012, you may opt to report the entire conversion in 2010 and also may choose to recharacterize less than you otherwise would to take advantage of 2010 being the final year for current tax rates, including possibly state tax rates as well as federal. You also have to deal with estimated taxes or added withholding to the extent your conversions stick unless you are sure to use the two year deferral. Then you have to address estimated taxes in 2011 instead of 2010.



Submitted by Newt Pearson on Mon, 2009-12-21 23:42

Hello Alan

Haven’t posted in some time and as usual you give superb responses.Good to hear from you.

Getting ready to pull trigger on my 1 st conversion (2009) and as always I get a little nervous about whether I’ve absorbed all the details and ins /outs .
We have what we consider a significant amt that we believe should be converted over next 8-10 years and these rechar strategies could save / pick up a little
extra reward if I’m implementing and understanding them correctly .

Thanks Again and hope I’m not pi in saying Merry Christmas and Happy Hanukkah



Submitted by Alan Spross on Tue, 2009-12-22 00:44

Thanks Newt and same to you.

Be sure you qualify to convert for 2009 (100,000 income limit), and after that the income limit is gone. If you are contemplating incremental conversions over several years using the top of a certain tax bracket to determine the limit, you would probably opt out of the two year deferral and just convert each year as before. That way you can definitely use your 2010 tax bracket. The conversion/recharacterization strategy is not affected by this, just the two year income deferral.



Submitted by Newt Pearson on Tue, 2009-12-22 17:54

Thanks again Alan

Hello Alan

Have a head cold…little fuzzy up top . Need a little more clarification .

Review… The M.M. conversion piece represents the total dollar amt that keeps me w/in the desired tax bracket. The stock conversion piece will be of the same amount . ( Either of 2 ) will push my
conversion amt twice as high as I desire ( however, I will recharacterize the amount that drops me back to my desired tax bracket ).

Qt. 1 –If stocks appreciate , can I choose/designate all of the M.M. piece to be rechar’ ed thereby keeping all of the appreciated stock in the roth ? and vice versa if stock depreciates ?

Qt. 2 –Or is there some formula / ratio where I can not designate either / or and approx’ly 50% of each must be recharacterized leaving about 50% M.M. and 50% stock in the roth

You brought up the 8606 that stirred up another qt

Qt 3 –Are you saying if I have any 8606 $ that every year… they must be factored into the computation in determining the taxable portion when converting ? Is it a percentage computation to total non – roth dollars that is used and
would thereby lower the taxable portion of the amount converted ? If yes , I can easily find the guidelines on computing . I had overlooked this so thanks for mentioning it .

Thanks again , Newt



Submitted by Alan Spross on Tue, 2009-12-22 19:10

1 and 2) Yes, you can recharacterize either one of the converted Roth accounts, ie either all the MM Roth or all the stock Roth. Of course, you can also do partials of either or both. For example, if both accounts gained exactly the same amount (unlikely), you could recharacterize half of each conversion and your income would be where you want it, and you would still have two smaller Roth accounts, one holding MM and the other holding stocks.

3) Yes, if you have ever made non deductible TIRA contributions OR rolled over after tax dollars from an employer plan, your IRA will have basis per Form 8606. Thereafter, every distribution OR conversion you execute will be partially taxable based on the 8606 calculation of the taxable amount. The reduced taxable amount ends up on line 15b of Form 1040. Therefore, if you want to convert enough to get to the top of your current bracket, you would gross up the conversion you planned by dividing it by the taxable factor from Form 8606.
Example: You have 15% basis after factoring in the conversion or any distributions. This is as of 12/31 of the conversion year, not the prior year. If you have 15% basis, then 85% would be taxable. You would divide your planned conversion by .85 and would convert this higher amount. If you end up with too high a converted amount and your income spills over into the higher bracket, you could simply increase the amount of your recharacterization to eliminate the higher bracket by reducing the taxable conversion.



Submitted by Newt Pearson on Tue, 2009-12-22 19:43

hello Alan

I’m perfectly clear now . Will convert w/in a few days .

Thanks again for eliminating some anxiety …my 1 st time w/ conversions and grasping some new concepts.

Thanks so much
newt



Submitted by george collins on Wed, 2009-12-23 13:31

Alan, since we can rechar any portion of a roth, I don’t see the reason for making two Roths to control the tax bracket. ??

My original plan was to convert over the next 5 yrs to maintain the tax bracket.(And as you recommended in the past).

Now I am thinking to convert all in 2010 in my one existing roth, and rechar what ever portion necessary to maintain optimum tax and market returns. And to possibly take advantage of the 2 yr split in 2011 and 2012 if the tax rates don’t jump more than 3%—I am currently retired, in the 28%, and if the tax cuts are not extended, I anticipate only a 3% increase in that bracket–back to the 31% bracket. I understand I have till Oct 2011 to make the decision.

jerry



Submitted by Alan Spross on Wed, 2009-12-23 17:27

The two accounts are not recommended in relation to tax bracket control. The rationale for two separate conversion accounts is:
1) The recharacterization math is simple; the amount that goes back to the TIRA is simply the % of the account balance equal to the % of the conversion to be recharacterized. With commingled accounts the calculation requires determination of the % gain or loss using the difference between an opening balance and a closing balance.
2) Conversion stratagies that involve multiple conversions and retaining only the best performing one(s) should be done to separate accounts so that a prior balance or investment experience of other conversions does not dilute the results of each single conversion. For example, if you converted 10,000 each on two different dates to the same Roth, and one stock gained 50% while the other lost 50%, you would have a balance of 20,000. If you wanted to recharacterize one of the conversions, then 10,000 would go back to the TIRA leaving 10,000 in the Roth and resulting in no gain for the Roth.

If done to two different accounts, you would recharacterize the loser and that account’s balance of 5,000 would be recharacterized. The other account is now worth 15,000 and holds a gain of 5,000 which is the conversion you retain. You end up with 5,000 more in your Roth and 5,000 less in the TIRA for the same tax bill on 10,000.



Submitted by fairira on Thu, 2009-12-24 07:43

Alan,

In your last post you said: “2) Conversion stratagies that involve multiple conversions and retaining only the best performing one(s) should be done to separate accounts so that a prior balance or investment experience of other conversions does not dilute the results of each single conversion.”

This thread and others in the past have dealt with this technique of creating several conversion Roth IRA’s invested very differently with the intent to recharacterize the one(s) with the actual greatest loss or smallest gain.

1. Which financial institutions accept this technique of treating a recharacterization independently of the performance in other conversion accounts? Fidelity? T. Rowe Price? Or ____?

My Roth IRA is at Vanguard which generally takes a conservative stance on IRS-related matters. Their position is to consider all of one’s Roth IRA’s as one Roth IRA, including when it comes to recharacterization calculations of a particular Roth IRA. That is, the calculations are done as if all the conversions had been made to a single Roth IRA.

2. Could you please provide the IRS regulations or other legal basis or arguments that one might cite to try to persuade Vanguard that the recharacterization of a particular conversion Roth IRA can properly be considered by itself and that the calculations should be independent of values in any other conversion Roth IRA’s.

Thank you for whatever help you can provide.



Submitted by Newt Pearson on Thu, 2009-12-24 14:44

fairira

As usual we are all awaiting Alan but since there have been quite a few views I’ld like to add a few comments and Alan or others can correct me as appropriate .
1.Deadline for converting is Dec 31 . Fido and VG require their converting forms for stock and ETF’s…might be too late unless you rush . Indexes and M.M. can be done on line or w/ rep …much quicker .
2. I deal w/ both fido and VG . Some time ago I set up zero balance roth’s w/ both . I think at least 1 of 2 was done on line other w/ rep. I’m not sure what would have happened if I had set up many . I would be surprised if either object but I don’t think they can catch it if you have m.m. or indexes and do on line . Log in and out for each transaction perhaps . VG does dot determine how the rechar’ing or tax laws are applied . Get the conversions into seperate (and zero balance) roth acc numbers and I don’t believe VG has anything to do with the rest except both told me this week their form must be completed to rechar. (can not be done on line or phone) .
3. I have also read about those who set up lots of seperate acc’s and placed different performers in each , however , I only have M.M. , bonds , foreign and us broad indexes . None of which are guaranteed to perform significantly
different . Since I have about 50% mm/bonds and 50% indexes/etf’s , I must get the mm/bonds over too . I have decided to do those with the equity portion every year and rechar the equity in only those periods
when they decline . This approach never places me in a bad guess period. For those that only convert stock… in those periods where all stock goes south you’re caught w/ the potentially 2 options , both bad…rechar all and lose that tax year or rechar down to your desired tax bracket but having paid more than if they had been done in flat or up periods . In my specific case , I need to be converting every year or I risk the 70 1/2 deadline … Another reason for converting equity along w/ M.M./bonds, I’ll never have a dilemma .
4.I/m sure Alan will confirm that the strategy you mention works best without some tricky calculations when and if rechar’ing if the various roth account numbers are new/fresh and have no old roth assets and each contain different likely performers as you mention .
5.To specially address your point 2. … If you are set up on line play around and see if you can get some roth’s set up without actually making conversions or call a rep and tell them you’re having trouble and as they set it up and if they lead you to plugging in the dollar $ tell them you need to rethink a small piece . Repeat process . If you have stock and need the brokerage set up you may run into a problem but I do know it must be done thru mail using there form . Could get tricky and all conversions hit same acc # . Like to hear back from you if you try the brokerage side…might be a good reason for me to replace all stock with indexes for future conversion strategies .
6. Reminder, taxes are due on all conversions even those amounts that you know will be rechar. In my strategy , 1/2 will be in a higher tax bracket. I may be tying up some funds but I’m only losing a very small amount on todays m.m. returns .

7. I have been told taxes are due in the quarter of the conversion. Does this mean the taxes are due in Jan 2010 ??? I file quarterly because I own a business . Do retirees have until 4/15 ? Do employees have same? Does everyone need to do a quarterly prior to tax filing to avoid a penalty??????



Submitted by Alan Spross on Thu, 2009-12-24 17:14

Here is a link to the IRS Reg regarding recharacterization earnings calculations. Note c (3) which is very direct and to the point.

http://www.taxalmanac.org/index.php/Treasury_Regulations%2C_Subchapter_A…

I discussed the Vanguard situation with them a few months back and they assured me that they recognize this Regulation and comply with it. The widely reported problem where multiple accounts are involved apparently arises from the nature of their account platform and use of sweep MM accounts. If additional accounts ever hold conversion moneys for even one day, all these additional accounts must be included. Same thing occurs if a Roth conversion is transferred to a different custodian. This is proper, however Vanguard’s account platform appears to create the problem of additional accounts where others that use a simple single brokerage account to hold all investments (Eg FIdelity or Schwab) are not prone to these problems. The Vanguard situation may also be partly explained by their requirement of a brokerage account to hold investments other than their own mutual funds while the mutual fund account platform continues for those investments. This also produces extra statements and paper. Vanguard is a fine company, but I do not recommend using them if you plan to recharacterize conversions, and that is more important than other advantages Vanguard might offer.

Note that when they combine accounts to compute earnings, it can work either in your favor or against you depending on the losers and winners, but it definitely reduces your control over the process and the outcome.

With respect to underpayment penalties, the most direct way of controlling them is to meet one of the safe harbors, usually paying in 100% (110% higher incomes) of the prior year’s tax liability in equal quarterly installments or through withholding or some combination. Withholding is applied equally throughout the year even when the withholding is taken at the end or beginning of the year. If you do not meet a safe harbor, you can get caught up in the dreaded annualized income installment method to reduce any penalty if you convert late in the year. This charges you according to when the income is realized. The current underpayment rate is only 4% and often does not produce a large bill if your payments do not meet a safe harbor.

Am not sure, but assume that if the IRS levies a penalty for a conversion, that a recharacterization would eliminate that penalty along with all the other retroactive features of a recharacterization.



Submitted by fairira on Thu, 2009-12-24 23:30

Alan,

I appreciate your comments, especially the link to the IRS Reg.

To clarify my prior post and questions, I had envisioned (but didn’t state) that one already has a “permanent” or continuing conversion Roth IRA (#1) and that one could now set up 2 new, additional Roth IRA’s (#2 and #3), initially with zero balances. One could then do a Roth conversion of (a) a given amount of a TIRA to Roth IRA #2, perhaps investing this in a money market or bond account, and (b) an equal amount of a TIRA to Roth IRA #3, perhaps investing this in a speculative stock or other investment. Roth IRA’s #2 and #3 would each have its own Vanguard mutual fund account no. and its own brokerage account no. and any sweeps from a given brokerage account would be to that Roth IRA’s money market account (MMA)–e.g.., a Roth IRA #2 sweep would go to the #2 MMA and not to the #1 or #3 MMA.

Q. 1: While the foregoing would involve extra statements and paperwork, do you think this is likely (or not) to satisfy Vanguard that a recharacterization of Roth IRA #2 would not involve Roth accounts #1 or #3 in any earnings computations?

Q. 2: I am unclear about your statement, “If additional accounts ever hold conversion moneys for even one day, all these additional accounts must be included.” Are you referring to a situation where conversion assets in Roth IRA #1 are moved into #2 or #3 and/or where a sale of brokerage assets in Roth IRA #1 sweeps into the #2 or #3 MMA?

Thank you very much for your further help.



Submitted by Alan Spross on Fri, 2009-12-25 01:34

1) Probably would be OK, but I am not sure exactly what triggers the inclusion of extra accounts. The safest thing would be to discuss with Vanguard up front what you are doing and get their assurance that the MM accounts would each be separately dedicated to a conversion account in a way that would not trigger a combined calculation with the other Roth conversion. Perhaps they are trying to resolve this issue since quite a few recharacterizations done over the last several months have irritated Roth customers. Whether there is a setup that alleviates the problem, I don’t know.

2) This would include a situation where a single MM account was the sweep account for more than one Roth account even if that other Roth just held regular contributions. The situation would also be triggered by any transfers between an account holding a conversion and any other Roth IRA. In some cases there is even a change of custodian before the recharacterization and the Roth owner has to then provide documentation from the first custodian of the opening balance and any other transactions so that the second custodian can attempt the calculation of earnings.

It has been several months since I talked to Vanguard about this and they may have made some changes. They were adamant that they observe the IRS Regs, but did not fully describe how their account platform might trigger combinations of accounts required by those same Regs. They were focusing on transfers ordered by the IRA owner and I was trying to contain the issue to accounts that were commingled solely due to the assigned MM sweep account.



Submitted by fairira on Fri, 2009-12-25 05:08

Alan,

Thanks very much for your comments and Happy Holidays to you.



Submitted by george collins on Wed, 2009-12-30 15:52

Alan, in the past we have discussed the merits of converting an IRA over several years to manage a tax bracket.
I have completed several analyses and have come to a different conclusion. I would also like your opinion of my latest strategy for conversion in 2010. And yes I am aware of the 2010 option. What think you of the following:

1. analysis with Merril Lynch has shown only a small delta in my case(0.5% NPV after 20 years growth), with the option of multiple years vs all in 2010, with or without the 2010 option. The new Fidelity Roth conversion planner(can not do multiple year) shows a benefit of the 2010 option over converting all in 2010. I have also manipulated the Fidelity Retirement planner for many conversion options. This planner takes income, expences, taxes and SS impact, etc into account . This also shows only a small difference in multiple years with the 2010 options best(4% after 35 years growth). I have the same results with my own spreadsheet.

My situation is as follows: IRA-460, current Roths-360K, retired w/ 130k income. Will not touch Roths–plan to leave to wife, then wife to kids. I am 64, wife 62. Plan is to leave wife with 40k taxable income, 70k SS income–taxes less than 5k/yr. If she needs more to use her current roth. Can pay taxes with post tax $$.

2. My plan is to convert 460k to three roths–230k in stocks, 115k in stocks, 115k in $$/bonds. This will enable me to keep the 2010 options and the multiple year option and potentially contain the 28% tax bracket with one of the 115K roths….. And, If market goes down, decide in 2011(thru oct 17) to what to rechar if anything, and still use the 2010 conversion if future tax changes warrent. My bet here is my current 28% tax bracket, if raised will only go to 31%.

“peace of mind” in all cases. Options with future tax increases. Am i splitting hairs ??

And Yes, I have discussed with several Professionals–more impressed with this forum.

jerry



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