Did Your Roth IRA Conversion Pass or Fail?
Most of us are familiar with the Roth IRA contribution limits and eligibility requirements, and, as such, we are able to avoid the associated tax consequences and penalties of ineligible or excess Roth IRA contributions. However, some Roth IRA rules, such as those that determine failed or ineligible conversions, are not as well known and could be a trap for the unsuspecting taxpayer. Here we review these rules. (For background reading, see Roth IRA: Bask To Basics.)
What Causes a Roth IRA Conversion to Fail?
A failed conversion is a Roth IRA conversion for which the Roth IRA owner did not meet the eligibility requirements. There are several ways a Roth IRA conversion could fail.
With the frequent market fluctuations, many taxpayers converting their non-Roth retirement accounts are attempting to take advantage of lower market value of securities in their retirement accounts. In trying to "play the market", individuals recharacterize conversions with the intention of reconverting these conversions when stock prices are lower. Caution must be exercised here as a reconversion that occurs before the allowable time could result in a failed conversion. An individual who recharacterizes a conversion cannot reconvert the same assets until the later of the following two times: The beginning of the year following the year the conversion occurred
- Thirty days after the recharacterization occurred
| Example 1
John converted his Traditional IRA to his Roth IRA in April 2013. At that time, the assets included in the conversion were valued at a total of $152,575. John had no other assets in his Roth IRA. In August 2013, John noticed that the value of the assets in the Roth IRA was only $125,500. Regardless of the depreciation in value, John will be required to pay taxes on the $152,575 - the original value of the conversion - unless the conversion is recharacterized in a timely manner. John recharacterizes the conversion in August 2013, and he may reconvert the assets to a Roth IRA no earlier than January 1, 2014, the beginning of the year following the year the conversion occurred.
The facts are the same as in Example 1, except John recharacterized the conversion on December 25, 2013. He may therefore reconvert the assets no earlier than January 25, 2014, which is 30 days after the recharacterization occurred.
Failing to Meet Statutory Requirements
For conversions that occurred before January 1, 2010, the individual was required to meet certain statutory requirements. If the individual did not meet these requirements, any conversions would be treated as failed conversions. Here are the requirements:
- The modified adjusted gross income (MAGI) requirement - An individual or couple whose MAGI exceeds $100,000 for the year was not eligible for a Roth conversion.
- The tax-filing status requirement - An individual who files (his or her tax return) as 'married filing separately' was not eligible for a Roth conversion.
These limitations were repealed effective January 1, 2010. Individuals, who did not meet these requirements in 2009 were required to recharacterize any conversion done in 2009.
Converting Required Minimum Distributions
If a distribution and a rollover contribution. For any year that an RMD is due, the first distribution always includes the RMD amount, and RMD amounts are not rollover eligible. This means that the first distribution from the account cannot be rolled over or converted to a Roth IRA. A retirement account owner or beneficiary must first distribute the RMD amount from the retirement account and then convert the desired amount from the balance to his or her Roth IRA.
Failing the 60-Day Requirement
In addition to completing a Roth conversion by means of a trustee-to-trustee transfer (of assets) between the same custodian or between two different custodians, an individual may complete a Roth conversion by receiving a distribution from his or her non-Roth retirement account and making a rollover contribution of the amount to a Roth IRA within 60 days (after receiving the distribution). Should the individual fail to meet this 60-day requirement, the conversion will be treated as a regular contribution to the Roth IRA, which is subjected to the contribution limits.
Consequences of a Failed or Ineligible Conversion
A failed or ineligible conversion is treated as a regular distribution from the Traditional IRA and a contribution to the Roth IRA. This treatment of the assets has the following implications:
Corrections for a Failed Conversion
Failed or ineligible conversions - except those that resulted from a failure to meet the 60-day requirement and conversion of RMD amounts - must be recharacterized to a Traditional IRA by the individual's tax-filing date, including extensions. If the individual filed his or her tax return by April 15, he or she is granted an automatic six-month extension and is allowed up to October 15 to recharacterize conversions. Recharacterizations must include all earnings or exclude any loss that occurred on the assets while they were in the Roth IRA. The IRS provides a special formula to determine the earnings or loss on a recharacterization.
Individuals should contact their IRA custodian/trustee regarding documentation and operational requirements for processing a recharacterization. Individuals should consult their tax professional for assistance with calculating the earnings or loss on a recharacterization, if that service is not provided by the Roth IRA custodian.
An ineligible conversion resulting from failure to meet the 60-day requirement should be corrected by removing the amount from the Roth IRA as a return of excess contributions. This amount is not eligible to be recharacterized to a Traditional IRA. (For more insight, see The Roth Converion Mulligan.)
Because you don't want to have to pay unnecessary penalties or taxes on your conversions, make sure these conversions are eligible and not subject to failure. If you are unsure, you should consult with your tax professional for assistance with determining if a Roth conversion is an ineligible or failed conversion. These professionals may also be able to help you implement the proper correction procedures.
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