IRA owners are presented some rare opportunities with Roth IRA conversions. One opportunity is to create a stream of tax-free income by converting a traditional IRA into a Roth IRA. The other opportunity is to reverse the conversion if you decide it was not the best move. Very few tax strategies come with second chances. Most of the time, once a transaction is completed the tax results are settled and can’t be changed.
After converting to a Roth IRA, you can reverse the conversion within a generous time frame. The reversal (known as a recharacterization) can be undertaken up to Oct. 15 of the year after the IRA was converted.
Here are some situations when you may want to recharacterize your Roth IRA back to a traditional IRA.
The primary reason for a recharacterization is the value of the IRA decreased significantly after the conversion. Remember when an IRA is converted to a Roth IRA you have to pay a tax on the value of the converted assets on the date of the conversion. That means if the value of the assets declines, you owe taxes on the higher value at the time of conversion. You are paying taxes on wealth that no longer exists.
When the decline is small or you believe it is temporary, you may not want to bother with a recharacterization. But when the loss in value is significant or you think it will last a while, a recharacterization is in order. Reverse the conversion and save your taxes. You always can do the conversion again, which we’ll discuss shortly. You’ll save a lot in taxes when you are able to convert the IRA at a lower value.
That’s why we’ve recommended in the past converting an IRA into several Roth IRAs. Have a separate Roth IRA for each asset in the traditional IRA. The assets are likely to have different investment performances. You can recharacterize any of the Roth IRAs that have negative investment performance and keep as Roth IRAs those with positive returns.
Another time for a recharacterization is when your situation changes. Suppose a change makes it likely your taxable income will be much lower in the year after the conversion than the year of the conversion. You may have lost or left your job, or you business might have suffered a decline. Or perhaps you now have some business or investment losses to deduct. In these cases, your taxable income and tax rate are likely to be much lower in the year following the conversion. You could save a bundle of money by recharacterizing the IRA and doing the conversion when your tax rate is lower.
You also benefit from a recharacterization when you discover a factor in your situation that wasn’t fully considered before the conversion. There are a number of variables to consider before a conversion, and you may have overlooked one that makes the conversion less attractive than it appeared. As one example, perhaps your future tax rate will be lower than you first thought.
A recharacterization is a simple process. In most cases you simply notify the IRA custodian that you want to recharacterize the Roth IRA, turning it back to a traditional IRA. This can be done in writing, over the phone, or on the Internet. The custodian changes the designation of the account to a traditional IRA. Most custodians charge no fee for this process. You also can recharacterize by transferring the IRA to a new custodian and stating in the paperwork that the Roth is being recharacterized as a traditional IRA. The recharacterization is reported on Form 8606 filed with the regular tax return, or with Form 1040X (amended tax return) if the regular return for the year of conversion already was filed.
A valid recharacterization includes not only the original converted amount but also all gains and income attributable to that amount.
The deadline for a recharacterization is the due date for the tax return for the year of the conversion, including allowable extensions. Even when the return for the year was filed by the initial April 15 deadline, the recharacterization can occur as late as the extension deadline, which is October 15. But if the return for the year was filed late without obtaining a valid extension of the deadline, the recharacterization deadline is April 15 of the year following the year of the conversion.
The recharacterization does not end your options with the IRA. You may convert all or part of the IRA again (a reconversion). A recharacterization followed by a reconversion can occur the later of during the next calendar year and after more than 30 days have passed since the recharacterization. For example, if you recharacterize the IRA on December 15, you can’t reconvert until after January 15. If you recharacterize on October 15, you can reconvert after December 31.
You can see that converting a traditional IRA to a Roth IRA is not the end of your planning. You should continue to monitor both the investment performance of the converted IRA and your personal situation. Adverse investment performance or a change in your situation could be good reason to recharacterize. If you choose to recharacterize, keep monitoring and planning. There could be a better opportunity to convert again in the future.
March 2010. RW