Earnings Allocations for Recharacterizations
By Kaye A. Thomas
Updated February 17, 2009
How to adjust the amount being moved between IRAs.
When you recharacterize a contribution or conversion, the amount transferred has to reflect the investment performance of the IRA holding that money during the time preceding the recharacterization. There's an easy way to do this when your facts are simple, but in other situations a calculation is required.
Switching everything
The simplified procedure applies if all of the following are true:
- The Roth IRA that received the contribution or conversion was an entirely new one (one that held nothing at all prior to the contribution or conversion).
- You want to undo or recharacterize the entire contribution or conversion, not just part of it.
- You haven't made any withdrawals (or received any distributions) from that IRA, or made any additional contributions.
In this case you'll satisfy the earnings allocation requirement if you simply move the entire balance of this IRA to the one that's supposed to hold it after the recharacterization. That's true even if you had a loss. In effect, you're transferring "negative earnings" in this case. You don't have to make up for the loss when you make the transfer — in fact, you're not allowed to do so.
Switching part
You may not be switching the entire account in a recharacterization, either because the contribution or conversion went into an existing Roth IRA, or because you want to change only part of the contribution or conversion. In these situations it's necessary to do an earnings allocation.
Normally you'll want the IRA provider to do this calculation. They've done it many times and have procedures in place to make sure they do it correctly. If they happen to make a mistake, you shouldn't incur any IRS penalty because it's reasonable for you to rely on the trustee. There are a few things you may want to know if you want to understand how they came up with their numbers or you suspect they made a mistake.
Look at the entire IRA
The one point that causes the most consternation is that the calculation is based on the overall performance of the IRA, not the performance of particular assets in the IRA. That's true even if you did a conversion that involved moving particular assets from a traditional IRA to a Roth, maintained the investment in those assets, and now want to move the same assets back to the traditional IRA. It seems logical that you would be able to do this, but the tax regulations are very clear in saying it isn't permitted. The result can be ugly, and people get upset with their IRA providers, but the trustees are just following the law.
Here's an example. Suppose you already have a Roth with $50,000 worth of investments, and you do a conversion in which you move $50,000 worth of XYZ stock from a traditional IRA into this Roth. Later in the year, the stock is worth only $20,000, so you want to
When you switch only part of an IRA, earnings must be allocated between the part you switch and the part that stays behind. There are two parts to the procedure. First you determine the amount of earnings the entire account had for the relevant period. Then you determine what portion of those earnings to allocate to the contribution you're switching. As we'll see, these rules are somewhat arbitrary. They can present you with a problem in some situations — and a planning opportunity in others.
| Normally you'll want the IRA provider to do the earnings allocation, because the calculation involves the value of the IRA on the date of the transfer. Besides, they're used to doing this calculation. We provide this information to help with your planning, and your understanding of the process. |
The
Computation Period
The period for which you're calculating earnings is called the computation period.
The regulations say this period begins on the first day of the taxable year in which you
made the contribution and ends on the date of the distribution (in other words, the day
the recharacterization transfer occurs). The effect of this definition is to take into
account earnings and losses that occur before the date of the contribution.
Example: In December you contribute to an IRA that already exists, then decide a week later that you want to recharacterize the contribution as a contribution to a different IRA. The rule tells you to look at the IRA's earnings for the entire year up to the date of the transfer, just as if you made the contribution on January 1. Depending on the situation, this rule can work in your favor or against you.
Notice that the computation period can be more than a year. If you make a contribution
in 1998, the computation period begins on January 1, 1998. You have until April 15, 1999
to make your recharacterization transfer (longer if you file your return on extension).
It appears that the computation period is tied to the year the
contribution is actually made, not the year for which it is made. For example,
you might have made a 1999 contribution to a Roth IRA in February, 2000. If you later decide to
recharacterize this contribution, the computation period would go back to January 1,
2000,
not all the way to January 1, 1999.
Amount of Earnings
The amount of earnings for the computation period is basically the value of the account
at the end minus the value of the account at the beginning, with appropriate adjustments
for contributions and distributions. The IRS likes to be precise, so they give us the
following formula:
- Begin with the value of the IRA immediately after the recharacterization transfer. Value in this case means fair market value, so if the IRA holds stocks that have changed in value, you have to adjust the value of the IRA accordingly.
- Increase this amount by the amount of all distributions from the account during the computation period — in other words, from January 1 of the year of the contribution to the date of the recharacterization transfer. That includes the amount transferred in the recharacterization, which gets added back in this step.
- Decrease this amount by the sum of the following:
- (a) the fair market value of the account as of the first day of the computation period (the first day of the year the original contribution was made), and
- (b) the contributions to the account during the computation period.
Note that this calculation will produce a negative number if the account had a loss during the computation period. That's OK when you're doing a recharacterization: in this case you'll use the allocation formula described below to allocate part of the loss to the amount you are recharacterizing.
| Different rule for withdrawal of excess contributions. If you take a corrective distribution to remove an excess contribution without recharacterizing it, you don't allocate losses to the excess contribution. You only allocate positive earnings. If you have a loss during the computation period you have to withdraw the full amount of the excess contribution. |
Allocation Ratio
Now we have the amount of earnings. You have to allocate some fraction of those
earnings to the contribution you're recharacterizing. The top part of that fraction (the
numerator) is the amount of the contribution. The bottom part (the denominator) is the
balance of the account on the first day of the computation period (January 1 of the year
you made the contribution you're switching) increased by the total amount of contributions
made during the computation period (including the contribution you're switching). You
divide the top part by the bottom part to get the allocation ratio. Then you multiply
that ratio by the earnings you determined earlier to see how much of the earnings you'll
allocate to the contribution you're switching.
Example
On January 1, 2000, your regular IRA had a value of $8,000. In March,
2000, you
contributed $2,000. In September, 2000 you decide you would be better off with a
contribution to a Roth IRA, so you want to recharacterize the $2,000 contribution. At that
time the IRA has grown to $11,200.
Your computation period is from January 1, 2000 to the date of the
recharacterization transfer. It's easy to see that the earnings are $1,200 (you started
with $8,000, put in $2,000 and ended up with $11,200). The top part of the allocation
fraction is $2,000 and the bottom part is $10,000 (the original $8,000 plus the $2,000
contribution). So the allocation ratio is $2000 divided by $10,000, or 20%.
Now multiply the $1,200 earnings by 20%. The answer is $240, and that
is the amount of earnings you must transfer (along with the $2,000 contribution) under the
recharacterization rule.
