Don’t rush the decision to reverse an IRA conversion. Some people who converted their traditional IRAs into Roth IRAs are moving too quickly to switch back.
This has been the year of the IRA conversion. Many people are taking advantage now that people of any income level can convert their traditional IRAs into Roth IRAs. Another incentive to convert an IRA in 2010 is the ability to defer the taxes on the conversion until 2011 and 2012.
Many people are comfortable converting their IRAs because they know the conversion can be reversed. If circumstances change or the conversion appears to be a mistake, a recharacterization turns the Roth IRA back into a traditional IRA.
There are some good reasons to recharacterize the Roth IRA. You may realize you don’t have the cash to pay the taxes on the conversion. Circumstances may have changed so that you’ll be in a lower tax bracket in the future, making conversion a bad idea. Or you may recalculate the effects of a conversion and conclude it isn’t the best option for you.
Probably the main reason to recharacterize the Roth IRA, however, is that the value of the IRA declined. You pay the conversion taxes based on the value of the traditional IRA on the date of the conversion. Should the IRA decline in value, you’ll be paying taxes on a value that no longer exists. That’s why the tax law gives you the opportunity to change your mind and recharacterize the IRA back to a traditional IRA. You can convert the IRA again in the future if you want.
With the decline in equity markets in recent months, some people are rushing to recharac-terize their Roth IRAs. It’s important not to recharacterize a Roth IRA too early. Here are some reasons to pause before recharacterizing and consider waiting until the deadline before deciding.
? After an IRA is recharacterized, you have to wait before converting it again. The waiting period is the later of 30 days and the next calendar year. Recharacterize in September or October and you won’t be able to reconvert until after Dec. 31. A lot can happen to the IRA’s value by then. It could bounce back to and perhaps even rise above the previous conversion value. Then if you want to reconvert your tax bill would be the same or higher than the bill for the conversion you did this year.
You want to recharacterize this early in the year only after a substantial drop in value that you believe is not temporary. Markets fluctuate, and you can’t time the exact best date to convert a traditional IRA. Recharacterize because of a value decline only when you’re confident you’ll be able to reconvert at a lower value than your initial conversion.
? Only conversions in 2010 come with the option of deferring the tax bill to 2011 and 2012. If deferral was not a reason for converting in 2010, this isn’t a factor for you. Otherwise keep in mind if you recharacterize now and reconvert in 2011 or later, you’ll pay taxes on that reconversion in the year you do it.
? You could pay higher taxes on future conversions. We already know the new 3.8% Medicare tax on higher income taxpayers will apply to conversions after 2012. Income tax rates in general, at least for many taxpayers, are likely to be higher after 2010. Consider the prospect of higher future conversion costs before undoing your 2010 conversion.
There are good reasons to recharacterize your IRA conversion. But be aware of the costs and don’t rush the decision. If you converted an IRA in 2010 and file your 2010 tax return or an extension request on time, you have until Oct. 15, 2011, to recharacterize. Be sure any decline in your IRA’s value is long-term and carefully consider what the tax cost of reconverting in the future would be before recharacterizing. Of course, when the option of deferring taxes on the conversion is important, a conversion in 2010 is the only time you have that option and you won’t want to reverse it.
RW October 2010.