Most of us are familiar with the Roth IRA contribution limits and eligibility requirements (if not, see this tutorial on Roth IRAs), 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.

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. (To find out what conversions, reconversions, and recharacterizations are and how they work, see the "Contributions" section of the Roth IRA tutorial.) There are several ways a Roth IRA conversion could fail. 

Premature Reconversion
With the frequent market fluctuations, many taxpayers converting their IRAs are attempting to take advantage of lower stock. 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: 

1. The beginning of the year following the year the conversion occurred
2. Thirty days after the recharacterization occurred

Example 1 John converted his Traditional IRA to his Roth IRA in April 2009. 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 2009, 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 2009, and he may reconvert the assets to a Roth IRA no earlier than January 1, 2010, the beginning of the year following the year the conversion occurred. Example 2 The facts are the same as in Example 1, except John recharacterized the conversion on December 25, 2009. He may therefore reconvert the assets no earlier than January 25, 2010, which is 30 days after the recharacterization occurred.

Failing to Meet Statutory Requirements
An individual must meet certain statutory requirements in order to convert assets from a Traditional IRA to a Roth IRA. Roth conversions that occur during the year in which the individual does not meet these requirements are treated as failed conversions. Here are the requirements:

1. The modified adjusted gross income (MAGI) requirement - An individual or couple whose MAGI exceeds $100,000 for the year is not eligible for a Roth conversion.
2. The tax-filing status requirement - An individual who files (his or her tax return) as 'married filing separately' is not eligible for a Roth conversion.

Individuals who amend tax returns for years in which a Roth conversion occurred should be cognizant of these requirements: an amendment could result in an eligible individual becoming ineligible if the MAGI or tax filing status changes on the amended return.

Ineligible Conversions

Converting Required Minimum Distributions If a required minimum distribution (RMD) is due from a Traditional IRA, the IRA owner must distribute the RMD from the Traditional IRA before converting the assets. Here's why: a Roth conversion is technically a distribution and a rollover contribution. For any year that an RMD is due form an IRA, 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. An IRA holder must first distribute the RMD amount from the Traditional IRA and then convert the desired amount from the balance to his or her Roth IRA. Note: For tax years before 2005, the RMD amount is added to the individual's modified adjusted gross income to determine eligibility to convert to a Roth IRA. For tax years beginning 2005, this rule is repealed. 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 Traditional IRA 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:

• The amount of the conversion will be treated as ordinary income and may be taxable.
• If the amount is in excess of the contribution limit for the year, the individual must remove the amount (from the Roth IRA) by the tax-filing date, plus extensions. Failure to remove the amount will result in a 6% excise penalty for each year the excess remains in the Roth IRA.
• If the individual was under age 59.5 when the failed conversion occurred, the amount will be subjected to the 10% early-distribution penalty unless the individual meets an exception. (For these exceptions see the "Distributions" section of the Traditional IRA tutorial.)

Corrections for a Failed Conversion
Failed or ineligible conversions - except those that resulted from a failure to meet the 60-day requirement - 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.

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.

Conclusion
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 can also help you implement the proper correction procedures.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.