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Estate Planning Alert: Roth recharacterization may save tax — October 15, 2011 deadline nears

If you did a Roth IRA conversion in 2010, and the value of the Roth IRA has decreased since the date of that conversion, you may be able to recharacterize the Roth IRA to a traditional IRA before October 17, 2011.

Roth IRAs remain a very useful planning tool. However, recent drops in the stock market may cause you to reconsider a 2010 conversion to a Roth IRA. For example, if you converted a $100,000 traditional IRA to a Roth IRA in 2010, and that account is now worth $90,000, you are paying tax on $10,000 that you no longer own.

If you “recharacterize” the Roth IRA to a traditional IRA before the applicable deadline, you will not be required to pay the income tax on the 2010 Roth IRA conversion (or, if applicable, you will be entitled to a refund of the tax you already paid), and your IRA will be treated as a traditional IRA. In other words, by recharacterizing your Roth IRA, the Roth IRA conversion is undone. 

You can consider reconverting in a future tax year (provided at least 30 days elapsed from the recharacterization). In the example given, if the value of the traditional IRA is still under $100,000 at the time of the reconversion, then you would have saved taxes.

The applicable deadline is the income tax return due date, including extensions for the year of the conversion. In the case of a 2010 conversion, if your 2010 return is on extension, the recharacterization must be accomplished by October 17, 2011. If you already timely filed your 2010 tax return, you can file an amended return to make the recharacterization election, provided the amended return is filed by October 17, 2011.

The recharacterization is accomplished by a trustee-to-trustee transfer from the Roth IRA to a traditional IRA before the applicable deadline. The transferred amount must include all of the amount being recharacterized and earnings (or losses) associated with the amount being recharacterized. This should be done in writing to the applicable custodians with appropriate instructions. A statement must be filed with the applicable tax return describing the recharacterization.

Consider 2011 Roth IRA conversions

If your traditional IRA or retirement account has been beaten down by the recent market slump, but you are looking at the long-term and confident of recovery, this may be an opportune time to make a Roth IRA conversion.

Many factors go into an analysis of a Roth IRA conversion, including availability of cash to pay tax on the conversion, expected tax rates at the time of the conversion and the ultimate distribution of the account, overall investment strategy and cash requirements during retirement, and other planning considerations. We refer you to our client alerts in June and November of 2009 for more detailed discussion of the Roth IRA conversion strategy:

Why All the Talk About Roth IRAs?

Are You Ready To Roth?

When converting a traditional IRA to a Roth IRA, the converted amount is taxed at the time of the conversion. Therefore, if the investments are expected to appreciate, it is more tax efficient to convert the account to a Roth IRA before that appreciation occurs. Amounts in the Roth IRA after the conversion will likely qualify for tax-free growth and distributions in the future, so you will save tax if the appreciation occurs inside the Roth IRA.

Any decision to recharacterize a Roth IRA to a traditional IRA or to convert a traditional IRA to a Roth IRA should be made in the context of your overall tax, investment, retirement, and estate planning. You should consult your tax return preparer for assistance in reporting such transactions. The affect of a Roth IRA conversion or recharacterization on minimum required distributions must also be considered if you are or will be age 70 1/2 in the year of such event.

For more information, please contact:

Michael G. Riley

or any of our estate planning attorneys by clicking on the link below:

Estate Planning

Our estate planning and probate services for individuals and families are focused on helping clients meet their estate planning objectives through income, estate and gift tax minimization. Our services include preparation of wills, living trusts, financial powers of attorney, charitable trusts, and related documents. We take a comprehensive approach to the planning process to ensure that the goals of the family are carried out and that the estate is appropriately managed.

Carl J. Grassi, President
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IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any tax advice contained in this communication (including any attachments), was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction matter addressed herein.

© 2011 McDonald Hopkins LLC All Rights Reserved. This Alert is designed to provide current information for our clients, friends and their advisors regarding important legal developments. The foregoing discussion is general information rather than specific legal advice. Because it is necessary to apply legal principles to specific facts, always consult your legal advisor before using this discussion as a basis for a specific action.