Roth IRA Recharacterization: Last Chance for a Roth Do-Over

by kristine on October 13, 2011

Time Running Out to Recharacterize a Roth IRA Conversion

If you converted a traditional IRA to a Roth and are unhappy with that decision, there’s still time for a do-over… but not much!

Roth IRA conversions can be recharacterized back to a traditional IRA, but only for a certain period of time. In general you can recharacterize a contribution or conversion any time up to your tax deadline, including extensions for the tax year in which you converted.  For example, if you did a Roth IRA conversion in July 2010, you have until October 15, 2011 to reverse that conversion.

So what is a Roth IRA recharacterization?

Basically, a recharacterization is when you reverse an IRA contribution or a Roth IRA conversion, and can be done for various reasons.  Some examples where you might want to recharacterize a contribution or a conversion include:

Contributions: You may have contributed to a Roth IRA early in the year, only to discover later that your income was too high to contribute to a Roth.  Or you may have earned less than you though you would, and now are able to deduct contributions to traditional IRAs.

Conversions:  The most common reason to recharacterize a conversion is when the stock market falls after you do a conversion; the purpose of the recharacterization is to reduce your tax bill that resulted from the original conversion.  Or you may just decide that a Roth IRA wasn’t the best tax strategy for you after all… there are many reasons to undo a Roth IRA conversion.

How can a recharacterization lower your tax bill?

Well, when you convert money to a Roth IRA, you have to pay taxes on the entire amount converted, even if the value of your account has declined due to changes in the market.  Many people who converted before the market tanked are paying taxes on money they no longer have.  For example, let’s say you converted $100,000 in late 2010.  Depending on how that money is invested, and based on the stock market performance in the past few months, that $100,000 could now be worth just $80,000, or even less.

Uncle Sam says you have to pay taxes on the entire $100,000; he doesn’t care that your $100,000 is only worth $70,000 or $80,000 now.  But if you’re like most people you don’t want to pay taxes on money you no longer have.  So what can you do?  Well, if you’re quick, you can still un-do the Roth IRA conversion as if it never happened.

So how can you reverse a Roth IRA Conversion?

To un-do a Roth conversion, simply contact your Roth IRA custodian.  They will probably require some paperwork for this transaction, but that’s okay, you’ll want to keep detailed records of both the original conversion and the recharacterization.

While market declines are the main reason people choose to recharacterize a Roth IRA conversion, there are other reasons as well.  You may discover that you can’t afford the tax bill that arises from converting to a Roth, or you may decide that it wasn’t the best tax decision for you in the first place.

Many people jumped at the chance to convert to a Roth when the IRS lifted the income limit in 2010 and later realized that it may not have been the best decision for them after all.  Just because you can convert to a Roth doesn’t mean you should convert to a Roth IRA.

Consult with a tax professional before converting or recharacterizing an IRA or Roth IRA account

As with any investment or tax transaction, you should consult with a financial professional who understands the tax rules of Roth IRAs before you convert to a Roth or recharacterize an earlier conversion to determine if it’s the right decision for you.

And if you decide to reverse a Roth IRA conversion that you executed in 2010, then call your financial institution immediately to make sure you make the deadline.  Generally the deadline is October 15 for a Roth IRA recharacterization, but since the 15th falls on a weekend, you have until Monday October 17 this year to do a Roth do-over.

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