Please mark your calendar with the following deadline:

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1 Apr-June 2018 Volume 9 Issue 2 The IRA Authority! IRA & Employer Plan Rules, News & Tips in Plain Language Special Issue Featuring: How to Cherry Pick Assets for a Recharacterization Appleby Retirement Consulting Inc. IRA Content, Coaching, Consulting Since the option to recharacterize a Roth conversion is not available for Roth conversions done 2018 and after, we decided to dedicate 253 Silvertop Drive this issue to a sub-topic on recharacterizations. Grayson, GA Tel: Fax: Annual IRA Calendar Customerservice@applebyconsultinginc.com Please mark your calendar with the following deadline: May 31, IRA Contribution Information (Form 5498) May 31 is the deadline by which IRA custodians are required to issue Form 5498, IRA Contribution Information (Form 5498) to IRA owners, unless the custodian fi les for an extension. Form 5498 can Content Page 1: IRA Calendar - Deadlines for IRA transactions Page 3: How to Cherry Pick Assets for a Recharacterization be used as an audit tool for IRA contributions, allowing interested parties to determine whether the IRA custodian properly reported the transactions. The following are some of the transactions that are reported on Form 5498 for 2017: - Box 1: Traditional IRA participant contributions for This includes contributions made January 1, 2017 to December 31, 2017 for 2017, and January 1, 2018 to April 17, 2018 for Box 2: Rollover contributions made to the IRA during Box 3: Roth IRA conversions to Roth IRAs during Box 4: Recharacterized contributions and recharacterized conversions between Roth IRAs and non-roth IRAs during Box 8: SEP IRA contributions received by the IRA custodian during 2017, regardless of the year for which the employer makes the contribution. Box 9: SIMPLE IRA contributions received by the IRA custodian during 2017, regardless of the year for which the employer makes the contribution Box 10: Roth IRA participant contributions for This includes contributions made January 1, 2017

2 The IRA Authority! IRA News & TIPS Page 2 Page to December 31, 2017 for 2017, and January 1, However, if an error occurs, it could result 2018 to April 17, 2018 for in a transfer being reported as a rollover and/or rollovers not being reported. If none of these transactions were made to the IRA, and the IRA custodian already reported the December 31 fair market value to the IRA owner by January 31, Form 5498 is not required to be issued for the IRA for the year. Requested transactions not processed. Unfortunately, paperwork sometimes does fall through the cracks, resulting in clients requests not being processed. For instance, a client s requested recharacterization RMD Indication The IRA Custodian is also required to indicate if the IRA owner is required to take an RMD for the 2018 calendar year. If an RMD is required, Box 11 should be checked. This does not apply to Inherited/Benefi ciary IRAs. may not have been processed, because the custodian overlooked or did not receive the paperwork. In some cases, the paperwork might not have been processed because it was not completed properly. A complete list of the information reported in each box of Form 5498 is available in the 2017 version of the IRS instructions, which is available here forms-instructions Form 5498 is not required to be fi led with the IRA owner s tax return. If the information reported on the Form 5498 is accurate, the IRA owner simply needs to keep it with the copy of his or her tax return. If the information is incorrect, the IRA custodian should be Clients Responsibility Your clients should review the form to determine if their transactions were posted correctly. Common mistakes include: IRA contributions made January 1 to April 18 not being applied to the correct tax year Transfers posted as rollover contributions and vice versa. Transfers are not reportable, while rollovers contributions must be reported on Form contacted immediately to determine if corrections can be made. Feature: How to Cherry Pick Assets for a Recharacterization There is a long-held belief in the IRA industry, that one is not permitted to cherry pick stocks or other assets when recharacterizing a Roth conversion or IRA contribution. But it can be done through application of

3 The IRA Authority! Page 3 IRA News & TIPS Page 3 a simple algebraic formula, which negates the need when one wants to choose whether to recharacterize to maintain multiple Roth IRAs for Roth Conversions. only certain assets- such as those that have lost market value. An IRA owner who wants to change a regular traditional IRA contribution to a regular Roth IRA (or vice versa) may do so by recharacterizing that contribution. The recharacterization process also allows an individual to reverse amounts that were converted from traditional retirement accounts (employer sponsored retirement plans and IRAs) to Roth IRAs, thereby nullifying the tax impact of the conversion. Why Some Believe Cherry Picking is Impermissible Cherry picking would matter only if one recharacterizes less than the full account balance. Such would be the case, if one performs: a partial recharacterization of a contribution or Roth conversion; or a full recharacterization of a contribution or conversion from an account that had Important Tax Law Change: In accordance with the Tax Cuts and Jobs Act (Pub. L. No ), Roth Conversions done after 2017 cannot be other funding activities (other contributions, conversions, rollovers, transfers, distributions, conversions, recharacterizations). recharacterized. However, regular IRA contributions can still be recharacterized. For the purpose of this article, the term partial recharacterization is used for both scenarios. A recharacterization must be completed by the IRA owner s tax fi ling due date, plus extension. And, one who fi les one s tax return by the due date, receives an automatic 6-month extension to complete one s recharacterization. When performing a partial recharacterization, any net income attributable (NIA) to that contribution or conversion must be included. When calculating the NIA, the performance of all assets held in the IRA, during the computation period, must be factored into the equation. One can choose to recharacterize a full or partial contribution or conversion. When performing a recharacterization of less than the full account balance, the IRA owner can choose to cherry pick which assets to recharacterize. Cherry picking is a useful option Example: If an IRA owner converted 10 different securities to a Roth IRA and wants to recharacterize only one of those securities; the NIA calculation must factor the performance of all ten securities plus any

4 The IRA Authority! Page 4 other assets that were held in the Roth IRA during important if Stock A loses market value- her advisor the computation period (defi ned below). instructs her to convert the 100 shares of Stock A to a new Roth IRA (let s call it Roth IRA #2) that holds no It is because of this requirement why many believe other assets. that it is not permissible to cherry pick assets for the recharacterization process. However, as is demonstrated below, it can be done by what some might consider reverse engineering the NIA formula. If the market value of Stock A falls, Mavis can simply recharacterize the full balance of Roth IRA #2, which would by default-include the NIA. Note: The NIA can be earnings or losses. Note: In such a case, Mavis would likely be advised to combine both Roth IRAs, after the deadline for The Problems that Cherry Picking Solves recharacterization has passed. Because of the long-held belief that cherry picking was not permissible for recharacterizations, industry experts often advise IRA owners to convert different assets to separate Roth IRAs. This would allow one to simply recharacterize a full Roth IRA balance for assets that one no longer wants to keep in one s Roth IRA. While this strategy can be practical, it could be less so if it becomes necessary to establish multiple Roth IRAs. Which could be the case if Mary wanted to convert 100 different securities or different asset classes to different Roth IRAs. The ability to cherry pick solves this issue. Example: Mavis has a Roth IRA (let s call it Roth IRA #1) that she started several years ago. Roth IRA #1 has a balance of $500,000, which consists of a mixture of different assets. Consider too, that if Mavis had already converted the 100 shares of Stock A to Roth IRA #1, she can still recharacterize the 100 shares and have the same tax impact as if the shares were converted to Roth IRA #2. Mavis wants to do a Roth IRA conversion of 100 shares of Stock A, from her traditional IRA. The Net Income Attributable Formula As noted earlier, any recharacterization must include the Knowing that Mavis can recharacterize any portion NIA for the recharacterized amount. of the conversion for any reason- which is especially

5 The IRA Authority! Page 5 A specifi c formula must be used to determine the eligible for the Roth IRA. NIA. But that is necessary only in certain cases. Application NIA Formula Required for No Application of NIA Formula Needed for Recharacterization of Full Balance If an individual recharacterizes the full balance of an account, then no calculation is required. This is because moving the full account balance in effect Recharacterization of less than Full Balance If less than the full account balance is being recharacterized, then the NIA formula must be applied to determine how much should be included in the recharacterization. incudes the NIA. Less than the full account balance would be Example: John makes a regular traditional IRA contribution of $5,500 to a new traditional IRA. The traditional IRA has no other funding activity. recharacterized under either of the following circumstances: Partial Recharacterization of a Regular IRA Contribution John wants to recharacterize the full contribution to his Roth IRA. Example: John makes a regular traditional IRA contribution of $5,500. John wants to recharacterize only $2,500 of the $5,500. At the time of recharacterization, the account had earnings of $500, bringing the total traditional IRA balance to $6,000. Partial Recharacterization of a Roth IRA Conversion Example: Suzie converts $100,000 from her traditional IRA to her Roth IRA. Suzie wants to recharacterize only $40,000 of the $100,000. To make the contribution a Roth IRA contribution, John would instruct his IRA custodian to recharacterize the entire $6,000 to his Roth IRA. Full Recharacterization from Account with Other Funding Activity Example: Mary converts $100,000 from her traditional IRA to her Roth IRA. The Roth IRA holds Caution: John must meet certain modifi ed adjusted assets from contributions and other conversions. gross income (MAGI) requirement, in order to be Mary wants to recharacterize the full $100,000. Even

6 The IRA Authority! Page 6 though this is a full recharacterization of the hundred thousand dollars, the NIA formula must still be used to determine the NIA to the hundred thousand dollars. The following is the NIA formula, as provided under Treas. Reg Contribution or conversion amount being recharacterized X (Adjusted closing balance- adjusted opening balance) Adjusted opening balance = NIA The following are terminologies one must understand, when applying this formula: Adjusted opening balance. This is: The FMV the Roth IRA that holds the contribution or conversion amount that is being recharacterized, at the beginning of the computation period; plus Any contributions or Roth conversions (including the amount being recharacterized), transfers, and recharacterizations made to the IRA during the computation period. Adjusted closing balance. This is: The FMV of the Roth IRA at the end of the computation period; plus Any distributions, transfers, or recharacterizations made from the IRA during the computation period. Computation period. This is: The period beginning immediately prior to the time that the contribution or conversion (that is being recharacterized) was made to the Roth IRA and ending immediately prior to the recharacterization of the amount. Example: Sue converted $32,000 to her Roth IRA on June 1, 2017 when it had a FMV of $96,000. Sue met with her tax advisor, who determined that converting only $24,000 would be most tax effi cient; and advised her to recharacterize $8,000 ($32,000-$24,000). Sue contacted her IRA custodian on March 1, 2018 and instructed them to recharacterize the $8,000. At that time, her Roth IRA had a FMV of $152,000.

7 The IRA Authority! Page 7 During the computation period, no other funding (contributions etc.) were made to the Roth IRA and no distributions or other debit related activity were made from the Roth IRA. The custodian applies the NIA formula to determine how much to include in the recharacterization, as follows: The adjusted opening balance is $128,000 [$96,000 + $32,000] The adjusted closing balance is $152,000. [$8,000 ($152,000 $128,000) $128,000] = $1,500. The NIA to the $8,000 March 1, 2018 contribution is $1,500. To recharacterize the $8,000, the NIA of $1,500 must be included. The total recharacterized amount would then be $9,500 ($8,000 + $1,500). Cherry Picking Assets for Recharacterization The cherry picking strategy is likely to be used to recharacterize assets that have lost market value. In such cases, the objective would be to determine the NIA attributable to the losers. Examples of Cherry Picking Assets for Recharacterization Example 1: Conversion done to Roth IRA that held assets other than the converted amount Assume that we have the same scenario above with Sue. Except that she only wants to recharacterize the stock that lost market value. Assume too, that when she converted the $32,000, it comprised of: 100 shares of Stock A, valued at $16,000 and 100 shares of Stock B, valued at $16,000 And, when she requested the recharacterization, the value of the assets is a total of $38,000, broken down as follows: 100 shares of Stock A, valued at $28,500 and 100 shares of Stock B, valued at $9,500

8 The IRA Authority! Page 8 Sue wants to recharacterize only Stock B. The following steps should be taken, to accomplish her objective. Step 1: Determine the NIA of the total amount converted The fi rst step would be to determine the NIA on the full $32,000 The adjusted opening balance would be: $128,000 [$96,000 + $32,000] The adjusted closing balance would be $152,000. [$32,000 ($152,000 $128,000) $128,000] = $6,000 The NIA to the $32,000 would be $6,000 Total value, along with NIA as of March 1, 2018 would be $38,000 ($32,000 + $6,000) Step 2: Determine the percentage by which the full conversion amount ($32,000) has grown NIA (growth) = $6, /32000 = The $32,000 has grown at a rate of 18.75% Step 3: Determine the NIA of the stock to be recharacterized While the overall growth is 18.75%, Stock B performed poorly. Sue must now determine how much of the $9,500 (the current FMV of Stock B) is NIA. The solution is to solve for X; when X, added to 18.75% of X = $9,500. The formula is: X X = 9,500 X = 9,500/ X = 8,000 NIA is $1,500 (9,500 8,000) Note: In this case, Sue must notify the IRA custodian of the NIA amount. To cherry pick Stock B, Sue would instruct the IRA custodian to recharacterize 100 shares of Stock B The current market value of stock B would be $9,500. The custodian s recharacterization form might have a section to input the NIA. Sue should add a note to the form, explaining the that conversion of the 100 shares represents a recharacterization of $8,000, plus the NIA of $1,500.

9 The IRA Authority! Page 8 This would be sufficient, as the processing and reporting done by the custodian does not make a distinction between the original market value of the conversion and the NIA. Instead, the amount is lumped into one total for reporting purposes. The result: Sue cherry picked Stock B for her recharacterization. Sue must provide the breakdown to her tax preparer ($8,000 plus NIA of $1,500), as it would be required for tax fi ling purposes. Proof: If Sue had converted Stock B to a separate Roth IRA, the result- recharacterizing the full balance of that account (100 Shares now valued at $9,500)- would be the same. Let s look at another example Example 2: Conversion done to Roth IRA, where the Roth Conversion is the only activity Bill converted $100,000 to his Roth IRA. This comprised of: 100 shares of Stock A, valued at $30, shares of Stock B, valued at $45,000 and 100 shares of Stock C, valued at $25,000 A few months later, the value of the assets totaled $125,000. The breakdown is: 100 shares of Stock A, valued at $45, shares of Stock B, valued at $65,000 and 100 shares of Stock C, valued at $15,000 Bill wants to recharacterize only the 100 shares of Stock C Step 1: Determine the NIA of the total amount converted The fi rst step would be to determine how much the $100,000 has grown. Since there were no other deposits (contributions, rollovers, conversions etc.) to, or distributions etc. from the Roth IRA- it s easy to see that the NIA is $25,000 ($125,000- $100,000).

10 The IRA Authority! Page 9 Step 2: Determine the percentage by which the full conversion amount has grown NIA (growth) = $25,000 25,000/100,000 = 0.25 The $100,000 has grown at a rate of 25% Step 3: Determine the NIA of the stock to be recharacterized While the overall growth is 25%, Stock C has lost market value. Bill must now determine how much of the $15,000 (the current FMV of Stock C) is NIA. The solution is to solve for X, when X, added to 25% of X = $15,000. X X = 15,000 X = 15,000/1.25 X = 12,000 The NIA is $3,000 ($15,000 -$12,000) To cherry pick Stock C, Bill would instruct the IRA custodian to recharacterize 100 shares of Stock C The current market value of stock C would be $15,000. The custodian s recharacterization form might have a section to input the NIA. Bill should add a note to the form, explaining the that conversion of the 100 shares represents a recharacterization of $12,000, plus the NIA of $3,000. The result: Bill cherry picked Stock C for his recharacterization. Proof: If Bill had converted Stock C to a separate Roth IRA, the result- recharacterizing the full balance of that account (100 Shares now valued at $15,000)- would be the same. Bill must provide the breakdown to his tax preparer ($12,000 plus NIA of $3,000), as it would be required for tax fi ling purposes.

11 The IRA Authority! Page 10 Trading Could Impact Cherry Picking Cherry picking works if the converted assets are still in the Roth IRA at the time of recharacterization. If those assets have been liquidated, then the formula does not apply. You Might Be on Your Own with NIA Calculations Not all IRA Custodians will calculate NIA amounts. And, it is unlikely that any will perform the calculation when the recharacterization involves cherry picking. In such cases, converting assets to separate Roth IRAs can be practical if there are no compelling reasons to maintain one Roth IRA- such as converting fi fty different securities, in which case, converting to fi fty different Roth IRAs would be impractical. Compliance Counts This technical explanation is only part of the recharacterization process. Others include meeting the IRA custodian s operational and documentation requirements, and the IRS s tax reporting requirements. Interested parties should coordinate the entire process, to ensure that all compliance requirements are met.

12 The IRA Authority! Page 11 Disclaimer This newsletter is a publication of Appleby Retirement Consulting Inc. The information provided in this newsletter is for general information purposes only, and is not intended to provide tax, legal, estate or retirement planning advice. Individuals should consult with their respective professional for advice on such matters. Every effort has been made to ensure the accuracy of the content. However, the information references rules that are in effect at the time of publishing and these rules might change. Nothing contained herein is intended to replace or circumvent the procedures for obtaining revenue rulings and/or technical advice. Such procedures are spelled out in the several revenue procedures currently in effect. Because of the complexities and the many recent changes in this area, the practitioner is urged to merely use this newsletter as one source of information. The material contained herein is protected by copyright under the copyright laws of the United States of America. No part of this newsletter may be copied or reproduced (electronically or otherwise), nor may this newsletter be shown to members of the public without the prior written consent of the author. For information contact: Appleby Retirement Consulting Inc. 253 Silvertop Drive, Grayson, GA Telephone: Fax: customerservice@applebyconsultinginc.com Writer: Denise Appleby, CISP, CRC, CRPS, CRSP, APA. Editor: Marjorie Wellington Please do not hesitate to contact us with any questions and/or comments about the content Appleby Retirement Consulting Inc. All rights reserved.