In a recent article, I briefly covered the topic of Recharacterization. The example that I gave was pretty simplistic – you converted an amount, and decided later to recharacterize that amount back to an IRA. What if it gets complicated?
There are some steps you can take in your conversion that will help you to recharacterize later, if the occasion should arise. These steps to structure the conversion are by no means required, they’d fit into a “simplifying your life” category, more than anything – or what I have heard referred to as a CYA* activity.
Structuring a Conversion
If you think you’ll want to come back and consider recharacterizing some of your conversion, you should start off with a brand-new Roth IRA account as the receiver of the conversion. This way you don’t have to worry about separating the money later on during the recharacterization (if that comes about).
In addition, depending upon the volatility of your holdings, you might want to chunk things up even further – especially if we’re dealing with a sizeable amount of money. You might consider chunking your account into Large-caps, small-caps, and global stocks, at the very least. There’s no limit on the number of funds you could split the holdings into, so if you wanted, you could open a new Roth account for each asset that you own.
The point to all of this splitting is that, in the event that one of the assets dramatically reduces in value through the year, since you’ve kept them segregated, it will be simple to recharacterize just that one asset. This way you can keep from paying higher tax on a dramatically reduced asset.
But wait! Doesn’t the IRS treat all IRAs as one account? Hold on, there – before you get all dressed up and jump off a chair: You’re making the assumption that there is consistency in the rules… and consistency in the rules would be a huge departure from the IRS’ proud, nearly 150-year track record. Besides, if the rules were consistent and made sense, then what would guys like me write about?
In the case of recharacterizing funds converted to a Roth IRA, the IRS only considers the account you converted into. This is why it’s important to (at the very least) start with a fresh new account – because any recharacterization in an account that included prior conversions and/or contributions will likely dilute the effect of the recharacterization. At the very least, commingling conversion funds will really complicate things, and lead to some potentially uncomfortable moments during the audit.
The more you’ve chunked your account, the easier it will be to choose only those funds that have fallen in value to recharacterize. Otherwise the benefit is diluted by any increases on other holdings.
* Not really sure, but I think CYA in this sense stands for “Chunk Your Accounts”. You may have a different interpretation.