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Life doesn't offer many opportunities for "do-overs". Usually, we have to live with the consequences of our decisions, even though we would have made different ones, had we only known. But by taking advantage of a technique called recharacterization, investors have a rare opportunity to undo a specific financial transaction if it doesn't unfold according to expectations. The opportunity occurs when investors convert a traditional, SEP, or SIMPLE IRA to a Roth IRA. Here's how it works.
Since 2010, all Americans who have a traditional IRA (SEP or SIMPLE IRA) are able to convert all or part of their IRA to a Roth IRA.1 This represents a unique opportunity, particularly for those whose adjusted gross income (AGI)2 exceeds $100,000. Prior to 2010, whether you were married or single, if your AGI exceeded $100,000, you were not eligible to convert. Once a Roth account has been established for at least five years and you are at least 59½ years old, all proceeds paid from the Roth IRA are free of income taxes. In addition, no minimum distributions at age 70½ are required, as long as you or your spouse is still alive, assuming your spouse is the first to inherit the account. If someone other than a spouse inherits your account, minimum, generally tax-free, distributions are required.3
So, what's the catch? Your IRA is subject to income tax in the year in which the conversion takes place. Generally, you are taxed on the converted amount that was not previously taxed, such as deductible contributions to an IRA, or on the balance in your current IRA that was rolled over from a prior employer's retirement plan. If you are one of the many Americans who are considering converting to a Roth IRA, you may want to do it as early in the year as possible.4
Let's look at a hypothetical situation: Chris chose to convert a $100,000 traditional IRA to a Roth IRA on January 5, 2013. The account appreciated and, by the end of the year, is worth $130,000. The value would be the same whether he had converted or not, but had he waited to convert, there would have been, theoretically, another $30,000 on which to pay taxes.
But, as we are painfully aware, investments do not always go up. What if Chris completed the hypothetical conversion as described above, but the investment plummeted 30% instead of growing 30%? The value falls to $70,000. Chris initially has lost money "on paper," but he still owes taxes on the original $100,000 converted. But as long as it is within the IRS prescribed time frame, Chris can choose to recharacterize the Roth conversion back to a traditional IRA, thereby erasing the conversion transaction and any tax liabilities that might have otherwise occurred. In this example, Chris has until October 15, 2014 to recharacterize. Therefore, Chris has from January 5, 2013, until October 15, 2014, to evaluate investment performance and decide whether to do nothing or to recharacterize. (October 15 represents the final tax-filing deadline with extensions. Taxpayers can file an amended tax form any time between April 15 and October 15 of the same year, and will be refunded overpaid taxes, if any).
Should Chris recharacterize, the conversion never happened, as far as the IRS is concerned. Chris owes no taxes on the $100,000 conversion, and the IRA is restored to the type of account (traditional IRA) it was before any changes took place. The account balance, alas, remains the same $70,000. But that presents an opportunity of a different kind.
Chris now can reconvert (do the conversion again) the remaining $70,000 to a Roth IRA and pay taxes on its value at the time of that conversion. According to IRS rules, Chris must wait more than 30 days from the rechacterization date or until the next calendar year, whichever is later, before he can reconvert. He also could choose to recharacterize his IRA but not reconvert.
IRS rules dictate when recharacterizations and reconversions can occur.
When Two Might Be Better Than One
Chris's tax advantage could potentially become even better if he decides at the time of the conversion to split the converted Roth amounts into two or more IRAs instead of one.
Suppose Chris split his hypothetical $100,000 conversion into separate $50,000 Roth accounts: one invested in the S&P 500® Index5 and the other in the Barclays U.S. Aggregate Bond Index.6 Now, let's further suppose that in 2013 the indexes perform very differently, with the S&P index losing 37% and the Barclays index gaining 5.2%, as they did in 2008. At the end of our theoretical year of 2013, the Roth IRA invested in the S&P 500 would be worth $31,500 and the Roth IRA invested in the Barclays U.S. Aggregate Bond Index would be worth $52,600, for a total of $84,100 in IRA investments. Of course, this example is hypothetical and the market may fail to perform in a similar manner under similar conditions in the future. It is also important to note that an investor cannot invest directly in an index and will not experience similar results.
When you recharacterize a Roth IRA, it is done on an IRA-by-IRA basis. Since Chris split the hypothetical IRAs, he can decide to recharacterize only the S&P 500 IRA as a traditional IRA, and thus avoid having to pay taxes on the $18,500 paper loss, while still retaining the opportunity to reconvert later at the lower value. The second IRA could be left intact, and Chris pays no additional taxes on the $2,600 gain in that fund.
On the other hand, if the Roth IRAs were not split but instead were still allocated to the same two investments within a single IRA, a decision to recharacterize would have caused Chris to return the entire $84,100 account ($31,500 in the IRA invested in the S&P 500 and $52,600 in the Barclays Aggregate Bond Index) to a traditional IRA. Chris would realize a tax savings on just $15,900 in this example, versus $18,500 had the investments been split.
In order to have this flexibility, Chris may have to pay additional fees, which vary by investment firm. But, we ask: Isn't, for example, an extra custodial fee worth the potential tax savings on $2,600 in our case study? [This potential tax saving does not take into account inflation, tax rate changes over time, or any additional fees/costs.] And once the recharacterization period ends in this example (October 15, 2014), the two Roth IRA accounts can be combined and the extra custodial account fee eliminated. However, combining accounts may result in the assessment of transaction costs or other fees.
The rules of converting differ when it comes to in-plan Roth rollovers, which were permanently expanded under the American Taxpayer Relief Act of 2012. Consequently, employees with eligible retirement plans (401(k)7, 403(b)8, or governmental 457(b)9 plans) can convert all vested pretax assets to designated Roth accounts, generally at any time. As with traditional IRA conversions, in-plan conversions are subject to taxation in the year in which the conversion takes place. But unlike with traditional conversions, in-plan Roth conversions are irrevocable. Recharacterization is not permitted. So investors should carefully consider the possibilities before committing to an in-plan conversion.
We recommend that you sit down with your financial advisor as soon as possible this year and decide whether the Roth conversion is right for you. You don't have to convert the whole amount in 2013. Some taxpayers may feel the tax liability on the full value of their assets is too much. You can convert your account in pieces, or not at all. (We also have a useful calculator tool to help you determine whether a conversion makes sense. See "Should I Convert to a Roth IRA?" located on our Retirement Calculators page in the Retirement section of our web site, lordabbett.com. Whatever you decide, you'll likely be better for the exercise.
[The examples in this commentary are hypothetical and for illustrative purposes only and do not represent the performance of any Lord Abbett product or specific investment. IT is intended to provide general education and is not intended to serve as the primary or sole basis for your investment or tax-planning decisions. Please keep in mind that the hypothetical values do not reflect the fees and charges associated with specific investment products. If included, results would be lower. Please note that indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.]
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 591/2, unless an exception applies.
A SIMPLE IRA plan is an IRA-based plan that gives small business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or non-elective contributions. All contributions are made directly to an Individual Retirement Account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.
A Simplified Employee Pension Plan (SEP – IRA) is a retirement plan specifically designed for self-employed people and small business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee's SEP-IRA.
Keep in mind that investing involves risk, including the possible loss of principal. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.