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How Self-Directed IRA Conversions and Recharacterizations Actually Work

conversions-recharacterizations-ira.pngEstimated reading time: 3 minutes

With tax payers having a better understanding of the Roth IRA and its tax-free attributes, many are choosing to convert their Traditional IRAs to Roth IRAs. Traditional IRA account holders know that although Traditional IRAs allow for the investment earnings to grow tax-deferred, eventually when assets are distributed, they are taxed. This is different than how Roth IRAs work. Roth IRAs on the other hand receive the same benefit of tax-deferment on the earnings, however this kind of plan will eliminate taxation on the earnings if the Roth IRA holder has satisfied the qualified distribution criteria.  Qualified distributions mean that the IRA holder has had a Roth IRA for a period of five years and attained one of the four events:

  1. Attainment of age 59 ½
  2. Disability
  3. First time home purchase (maximum lifetime limit of $10,000)
  4. Death 

By converting a Traditional IRA to a Roth IRA it will eventually eliminate taxation of future earnings on investments.  A conversion involves distributing the assets from a Traditional IRA and contributing the same asset to the Roth IRA. Although conversions are taxable, the 10% early distribution penalty is waived for any amounts converted regardless of the IRA holder’s age. 

IRA holders may choose to convert their Traditional IRA investments in cash or in-kind.  In-kind means that if the investment is in the form of a property (e.g. real estate, securities), the property can be distributed without selling the property and the same property contributed to their Roth IRA.  Since the distribution is taxable, the property distributed will be taxed based on its fair market value at the time of the distribution. With taxation involved in the transaction, careful tax planning must be put into consideration to account for the possible additional taxable income in the year of the distribution.

The amount of tax liability may come as a surprise for some who conduct a conversion once they receive the IRS Form 1099-R from their custodian. There is a way to reverse the conversion transaction and avoid the tax liability. The means of undoing the conversion is by taking converted asset out of the Roth and returning it to the Traditional IRA. This transaction is called a recharacterization. The deadline by which a recharacterization must take place is by the individual’s tax return due date plus extensions.  If the tax payer filed their taxes timely, they are given an automatic six month extension without having to physically file for one. The extension deadline is typically October 15th of the following year.   

As an example, a taxpayer holds an asset (i.e., single family home) under their Traditional IRA worth $200,000 at the time of the in-kind conversion. Note that the taxpayer will need to include the fair market value of $200,000 as part of their taxable income for the year. A couple of months after the conversion, the property began to fluctuate in value because of an unforeseen market down turn. The taxpayer does not want to pay tax on the amount converted (i.e, $200,000) which is now higher than the property’s current fair market value. The taxpayer may undo the conversion and avoid the tax liability by recharacterizing the conversion back to their Traditional IRA. This must be accomplished on or before the recharacterization deadline.

You can use recharacterizations in numerous ways: you can switch a current year contribution from one type of IRA to another to correct an excess contribution, reverse a current year conversion, and correct a SIMPLE IRA transfer to a Traditional IRA that occurred before satisfying the 2-year rule. This states that SIMPLE IRAs are not allowed to be moved to Traditional IRAs within a two-year period beginning from the date of the initial contribution.

To learn more about recharacterizations, or about investing in alternative assets, contact any of our offices to speak with one of our knowledgeable IRA specialists.

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