In 2010 a record number of traditional IRAs were converted into Roth IRAs. Financial services firms report a stampede of IRA owners rushed to convert in December. Now, it’s time for the next stage. Those of you who converted shouldn’t completely move on to other matters. You should monitor converted IRAs and re-evaluate whether you made the right decision.
You have the option to reverse the conversion, known as a recharacterization. The deadline for a recharacterization, if you file your 2010 return on time, is the last day for filing the tax return for the year of the conversion, including extensions. The deadline for extensions of 2010 individual income tax returns is Oct. 17, 2011. (It would be Oct. 15, but that’s a Saturday.)
A recharacterization is easy. You contact the IRA custodian and say you would like to recharacterize all or part of the 2010 conversion. It’s usually a simple matter of the custodian redesignating the Roth IRA as a traditional IRA. If you did the conversion by moving traditional IRA funds into an existing Roth IRA, you’ll have to designate the amount of funds to remove from the Roth IRA and transfer to an existing or new traditional IRA.
There are several reasons you might want to reverse an IRA conversion.
? The tax law has changed. At the end of 2010 it seemed apparent that income tax rates would rise in the following years. After the election, however, a deal was made to extend the 2010 income tax rates for 2011 and 2012. Some people rushed conversions in late 2010 to take advantage of the 2010 tax rates. They might reconsider their decisions in light of the new tax law. Instead of converting an entire IRA in 2010, for example, they could decide to convert portions of it over several years so they aren’t paying all the taxes in one lump sum.
Also, 2010 was scheduled to be the last year that the phase outs of personal exemptions and itemized expenses for higher income taxpayers were suspended. Some people did full conversions in 2010 to avoid triggering the phase outs in following years. But the suspension of the phase outs was continued, so you might not want to bunch an entire conversion in 2010.
? Your tax or financial situation might have changed. If it appears you’ll be in a lower tax bracket in 2011 or 2012 than in 2010 (say, because of a decline in income), you could be better off doing the conversion then instead of in 2010. Or you might have encountered an unexpected large expense and no longer have the money to pay the income taxes on the conversion.
? There are tax consequences to conversions that sometimes are unexpected, as we’ve explained in past visits. The higher gross income from the conversion could trigger higher taxes on Social Security benefits, higher Medicare premiums for a year, and other disadvantages. Some people didn’t realize this at the time of the conversion or are learning that their conversions combined with other factors are increasing those costs. If so, a recharacterization might be in order.
? The reason for most recharacterizations probably is a significant decline in the value of the converted IRA. You pay income taxes on the value of the converted amount on the day of the conversion. When the Roth IRA subsequently declines in value, most people don’t want to pay taxes on wealth that no longer exists. They recharacterize, and convert again later at a lower value.
Most IRAs that were converted in 2010 probably have higher values now. But some probably have declined in value. Others could fall before the deadline for recharacterization if the markets have a correction or the economy slows. Monitor the value of your Roth IRA until the deadline.
You probably don’t want to reverse the conversion for a modest decline or one that likely is temporary. But a substantial decline in value or one that doesn’t appear to be a temporary market correction is a good reason to recharacterize.
Like a conversion, a recharacterization doesn’t have to be all or nothing. You can reverse part of your conversion or all of it, whichever suits your circumstances.
Once you recharacterize back to a traditional IRA, you can convert back to a Roth IRA after a waiting period. The government doesn’t want you to recharacterize and immediately re-convert. You have to take the risk the assets could rise in value again. This is one reason why you don’t want to recharacterize when a decline in value is modest or temporary.
The waiting period is the later of 30 days and the next calendar year. If you recharacterize in September, you can’t convert that amount again until the following January 1. Also, you’re allowed only one reconversion annually.
Those who converted IRA in 2010 should continue monitoring both their IRAs and their personal tax and financial situations. They could find it advantageous to reverse the conversion before Oct. 17.
RW March 2011.
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