This is the fourth in a series of Technical Updates, covering Roth IRA issues, including 2010 law changes, plan to Roth IRA rollovers, Roth IRA conversions, recharacterizations and reconversions, and taxation issues associated with Roth IRA transactions. Part 3 discussed the definition of recharacterization and how to recharacterize an IRA contribution. This Part 4 discusses additional rules relating to recharacterization and reconversion of IRA contributions.

Q-1: How long do I have to recharacterize a contribution for a particular taxable year?

A taxpayer generally must make a recharacterization election (and complete the transfer to the second IRA [IRA 2]) on or before the due date (including extensions) for filing the taxpayer’s Federal income tax return for the taxable year for which the taxpayer made the recharacterized contribution to the first IRA (IRA 1). However, the taxpayer who does not meet this deadline still may recharacterize a contribution, provided the taxpayer: (1) timely files his/her return for the year he/she should have made the recharacterization election; and (2) takes appropriate corrective action within 6 months from the due date of the return excluding extensions (e.g., October 15, 2010, for returns due April 15, 2010). The appropriate corrective action consists of: (1) notifying the trustee(s) of the intent to recharacterize; (2) providing the trustee with all of the necessary information; and (3) having the trustee transfer the contribution. The taxpayer then must amend his/her tax return to show the recharacterization. The taxpayer must amend by the regular due date for amending a return (generally three years after the later of the due date or the filing date of the return), and should write “filed pursuant to section 301.9100-2" on the amended return.

Q-2: If I make a traditional IRA contribution (IRA 0) and subsequently transfer the IRA contribution (with net earnings) in a tax-free transfer to a different IRA (IRA 1), can I still recharacterize the contribution as a Roth IRA (IRA 2) contribution?

Yes. For purposes of the recharacterization rules, the IRS treats the contribution as a contribution to the initial IRA (IRA 0), and treats the recharacterized contribution as made to the Roth IRA (IRA 2) on the same date (and same taxable year) as the taxpayer made the initial contribution to IRA 0. The same result would apply if the initial contribution and tax-free transfer were to a Roth IRA rather than a traditional IRA, and the taxpayer thereafter recharacterized the contribution to a traditional IRA.

Example #1. On March 1, 2010, John opens an IRA at Bank B and makes a $4,000 traditional IRA contribution. On September 1, 2010, John transfers the entire IRA (in a tax-free transfer), with $200 earnings to a new IRA at Bank C. On February 1, 2011, John decides to recharacterize the Bank C IRA as a Roth IRA. For tax purposes, the IRS treats John as having made the $4,000 contribution to the Bank C Roth IRA on March 1, 2010. Consequently, John may not deduct the March 1, 2010 contribution on his 2010 tax return. However, the earnings on the $4,000 contribution are treated as Roth IRA earnings.

Q-3: If I recharacterize a contribution, does the IRS treat the recharacterization as a rollover for purposes of the one-rollover-per-year limitation?

No. The one rollover per year limitation that otherwise applies to an IRA does not apply to a recharacterized contribution. Under this limitation, if a taxpayer makes a tax-free rollover of any part of an IRA distribution, the taxpayer generally cannot, within one year of the date of receipt of the IRA distribution, make a tax-free rollover of another distribution from the same IRA or from the IRA into which the taxpayer made the tax-free rollover. However, the IRS does not treat recharacterizing a contribution as a rollover for purposes of this limitation.

Example #2. On June 1, 2010, Emma takes a distribution of $100,000 (pre-tax dollars) from her 401(k) plan and rolls over (converts) the distribution to a Roth IRA at Bank M. On August 15, 2010, she rolls over $50,000 of the IRA to a new Roth IRA at Bank N. On October 15, 2010, Emma elects to recharacterize $20,000 of the Bank M Roth IRA to a traditional IRA at Bank P. The recharacterization does not violate the one-rollover-per-year limitation.

Q-4: If I convert a traditional IRA to a Roth IRA, and then transfer part or all of the conversion amount back to a traditional IRA in a recharacterization, can I subsequently reconvert that amount from the traditional IRA to a Roth IRA?

Yes. However, once you convert an amount from a traditional IRA to a Roth IRA, and then recharacterize an amount back to a traditional IRA, you may not reconvert that amount from a traditional IRA to a Roth IRA before the later of: (1) the beginning of the taxable year following the taxable year in which you converted to a Roth IRA; or (2) the end of the 30-day period beginning on the day on which you transfer the amount from the Roth IRA back to the traditional IRA in a recharacterization.

Example #3. Assume Ellen converts $20,000 of her traditional IRA to a Roth IRA on March 1, 2012. Because of a significant decrease in the market value of the Roth IRA, Ellen decides to recharacterize the contribution on November 15, 2012, when the total value of the contribution has decreased to $11,000. Ellen decides to reconvert $10,000 of her traditional IRA on January 10, 2013. She may reconvert at any time during 2013, since 2013 is the taxable year following the 2012 conversion year, and is more than 30 days following her recharacterization.

The IRS treats an attempted reconversion prior to the time permitted in this paragraph as a failed conversion. A taxpayer may recharacterize a failed conversion.

Q-5: How do I report a recharacterization for tax purposes?

Remember that the IRS will treat a recharacterized conversion contribution (including a rollover from a qualified plan) as if the conversion had not occurred. In the case of a regular contribution, the IRS will treat the recharacterized contribution as having been contributed originally to the second IRA (IRA 2) on the same date that the taxpayer made the initial contribution to the first IRA (IRA 1). The IRS treats earnings (or losses) transferred with the recharacterization as having occurred in the second (transferee) IRA. The reporting rules differ depending on the source of the original contribution, and whether the taxpayer recharacterizes all or part of the contribution. A taxpayer uses Form 8606 to report nondeductible contributions to a traditional IRA and conversions to a Roth IRA. Some reconversions require attaching a statement to the taxpayer’s Form 1040. The instructions to Form 8606 provide helpful guidance for reporting each type of recharacterization transaction.

We will discuss the Roth conversion process at the Advanced Pension Conference. In addition, Roth IRAs, conversion and related IRA issues will be the subject of ERISA Newsletter 2010-1. We also have added Roth IRA conversion and recharacterization forms to ERISA Forms. The ERISA Newsletter and ERISA Forms are part of The Pension Library.