Has the Value of Your Roth IRA Declined Since a Recent Conversion?

During the first week of August the Dow Jones Industrial Average and the S&P 500 fell by 11.2% and 13.3%, respectively. This unfortunate situation creates an opportunity for those who may have converted a regular IRA to a Roth IRA in 2010 or an earlier point in 2011.

Over the last two years we have advised that our clients with sizeable balances in their traditional retirement accounts convert these accounts to Roth IRAs for a variety of reasons. The conversion of a traditional retirement account to a Roth IRA causes the balance of the account to be subjected to income tax at the individual's highest marginal rate. Those who converted to a Roth IRA during 2010 or 2011 can take advantage of the recent substantial drop in account values by recharacterizing the conversion, which essentially reverts the Roth IRA back to its original status. You may then reconvert to a Roth IRA at a lower account value, thereby reducing the tax liability from the conversion. There are slightly different considerations for Roth conversion that took place during 2010 and those that took place in 2011, which will be explained below.

2010 Recharacterization:

For 2010, the S&P 500 opened at 1,117, hit a low of 1,023 during August and closed out the year at 1,258. At the time of writing this article the S&P 500 is at 1,145. If your conversion was well timed during 2010, it is possible that the current value of your account still exceeds its value as of the date of its Roth conversion. However, if the market continues to decline as the year goes on, it may be worth re-examining whether a recharacterization would benefit you. Technically, you have until October 17th, 2011, to make this determination. However, you should keep in mind that the logistics of making the recharacterization and reporting the impact on your tax return may take some time.

If you converted to a Roth IRA in 2010 during a period when market values exceeded the current 2011 market lows, then a recharacterization could be of benefit to you. Assume for a moment that you had a traditional IRA with a market value of $2,000,000, the value of your account exactly correlates with that of the S&P 500, and that you originally converted this account to a Roth IRA on 12/31/2010, when the S&P 500 reached its high for the year at 1,258. Further, assume that your marginal federal income tax rate is 35%. Upon the conversion of your retirement account to a Roth IRA you would have incurred a federal tax liability of $700,000. Under the current assumptions, the value of your account would have fallen by 11% to $1,780,000 and let's assume the value stays there for the next 30 days. If you were to recharacterize the conversion, basically undoing the original Roth conversion, and then 30 days later (the time restriction imposed by Congress) reconvert the account back to a Roth, several tax implications would happen. The $700,000 tax liability from the 2010 conversion would be eliminated by the recharacterization. Then upon reconverting to a Roth IRA in 2011 at the lower account value of $1,780,000, a 2011 tax liability of $623,000 would be generated. While fundamentally your strategy of converting to a Roth and the income tax and estate tax benefits it offers are still in place, you have reduced the tax incurred by the transaction by $77,000. If you factor state taxes into the analysis, the savings become even more substantial.

While the above analysis illustrates that the current market volatility may provide the opportunity to substantially reduce the tax costs associated with converting a retirement account to a Roth IRA, there are many other important considerations. You should discuss the following with your tax advisor (note that if you converted to a Roth IRA during 2010 time is of the essence as the deadline to recharacterize the Roth conversion is October 17, 2011):

  • whether you will need to amend your 2010 return to account for the recharacterization;
  • the timing of recharacterizing the conversion back to a traditional IRA;
  • the timing of reconverting the traditional IRA back to a Roth IRA and the implications of continued market volatility;
  • the impact on the timing, effective tax rate and net amount of  income taxes resulting from the conversion;
  • the logistics of making the recharacterization and the reconversion back to a Roth IRA; and
  • the methods of hedging the reconversion to mitigate the risk of adverse market fluctuations.

2011 Recharacterization:

The analysis for recharacterizing a 2011 conversion is similar in most respects for 2010 conversions. There are two significant differences; first, you have until October 15, 2012 to implement the recharacterization, and second, if you recharacterize in 2011, you cannot reconvert the account to a traditional IRA until January 1, 2012.

The S&P 500 opened the 2011 year at 1,258 and is currently trading at 1,145. Through August 8, 2011 the average value of the S&P was 1,304. Nearly everyone that converted their retirement account to a Roth IRA during 2011 will have the potential to benefit from a recharacterization and reconversion. This is because the recent market downturn has probably lowered the value of the account to a point well below the value at the time of the original conversion. However, whether there is an actual benefit will depend on the level of the market at the point of reconversion to a traditional IRA, which cannot be sooner than January 1, 2012.

The following example will demonstrate the potential income tax savings of a recharacterization to those that originally converted their retirement account to a Roth IRA during 2011. In order to illustrate this point the following assumptions are used: the value of the account on the day it was converted is $2,000,000; the value of the account exactly correlates with the S&P 500; at the time of the conversion the value of the S&P 500 was its average for the year of 1,304; and that the marginal federal tax rate is 35%. Additionally, assume that the recharacterization took place on August 8, 2011, and the account is reconverted to a Roth IRA on January 1, 2012. Finally, hypothetically we will assume that the S&P 500 gains 25 points during the statutory waiting period for a reconversion to a Roth IRA for a value of 1,159.

Upon the original 2011 conversion of the $2,000,000 retirement account to a Roth IRA, a federal tax liability of $700,000 was incurred. Upon the recharacterization of the account, that tax liability is eliminated. Then on January 1, 2012, the account is reconverted while the S&P 500 is at the hypothetical 1,159. At this time the account, which tracks the S&P 500, is now valued at $1,777,607. This second conversion to a Roth in 2012 generates a tax liability of $622,162. Fundamentally, all the income tax and estate tax benefits of converting to a Roth are still in place. However, by recharacterizing the original conversion and then later doing a second conversion, a federal income tax savings of $77,837 has been realized. The savings become even greater when state income taxes are factored in. If the market fares worse during the reconversion waiting period, the tax savings will be larger. Conversely, if the market fares better, the tax savings will be smaller and could potentially be eliminated entirely. Ideally, the reconversion to a traditional IRA would take place at the market's lowest point, which is impossible to predict with certainty.

While it is impossible to predict the market's low and where it will be after the waiting period for a second conversion to a Roth IRA, the above example illustrates that you may obtain some benefit from hindsight. If the market remains at a reduced level or continues its decline, recharacterization could substantially lower the tax costs of the conversion to a Roth IRA.  However, there are many other important considerations that are unique to each individual situation.  Please contact your tax advisor to discuss whether a Roth IRA recharacterization or a conversion of a traditional IRA to a Roth may be appropriate for you.