Earnings Allocations
How to allocate IRA earnings when you make certain changes.
Hold Everything!
Material on this page needs updating. We'll revise it for
current law soon. Until then, please note that the information
below is outdated and therefore not necessarily correct.
When you recharacterize a contribution, you have to transfer the contribution and
the earnings on that contribution to a new IRA. If you're switching from an IRA that
doesn't hold anything other than the contribution you're switching (and earnings on that
contribution) you simply switch the entire IRA. But if you're only switching part of the
IRA, you need to know how much of the earnings belong to the part you're switching and how
much belong to the part that stays behind.
Switching Everything
There's a simplified procedure that applies if all of the following are true:
- You contributed the amount being recharacterized
to a new IRA (one that held nothing at all prior to the contribution).
- 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 requirement to transfer the earnings if you transfer the
entire balance of this IRA to the new recipient IRA. 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
When you switch only part of an IRA, you need to allocate earnings 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.
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