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When Should You Reverse an IRA Conversion

Last update on: Nov 13 2017
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IRA owners who convert their traditional IRAs to Roth IRAs during the year need to continue monitoring their accounts. It might be advantageous to reverse an IRA conversion.

Reversing an IRA conversion, known as a recharacterization, can be done any time before the due date for the tax return for the year of the conversion, including extensions. The extension date can be used for the recharacterization even if the taxpayer filed the return by April 15. For example, if an IRA was converted in 2008, the recharacterization can occur any time up to Oct. 15, 2009, regardless of when the 2008 return is filed.

Reversing a conversion usually is done simply by informing the IRA custodian to change the Roth IRA back to a traditional IRA. The custodian might charge a fee. If the tax return for the year was not already filed, probably no other action is required. If the return was filed and taxes on the conversion paid, an amended return should be filed to record the recharacterization and receive a refund of the conversion taxes.

After a recharacterization, the IRA owner has two choices. The IRA can be left as a traditional IRA, or it again can be converted to a Roth. The second conversion cannot be made in the same calendar year as the original conversion. A second conversion also cannot occur until more than 30 days have passed since the recharacterization.

There are a few times when an IRA owner might want to reverse a conversion.

One reason to recharacterize is that income for the year (excluding the converted amount) unexpectedly exceeds the $100,000 ceiling for a conversion. When income exceeds $100,000 a taxpayer who wants to avoid penalties has to recharacterize and wait for another year when the $100,000 threshold isn’t breached or does not apply.

Another reason to recharacterize is the value of the IRA declined after the conversion. Remember that when a traditional IRA is converted to a regular IRA, the amount converted is included in gross income for the year and taxed as ordinary income just as though it were distributed.

The tax is computed on the value of the converted amount on the date of the conversion. If the value declines after the conversion, taxes still are due on the previous higher value. To avoid paying taxes on the higher value, the IRA can be recharacterized. The owner can decide to convert again in a new calendar year and after at least 30 days have passed.

A third reason to reverse all or part of a conversion is the conversion pushes the IRA owner into a higher tax bracket. Someone who is eligible for a conversion probably is in the 25% tax bracket before the conversion. The owner might decide to convert only enough of the IRA to stay in the 25% bracket, or perhaps the 28% bracket. When converting all of a large IRA boosts the tax rate too much, the owner can recharacterize part of the converted amount and convert the rest in future years.

Under this process, it could take several years to completely convert traditional IRAs to Roth IRAs. But the conversions would be done at a lower tax cost, because the multi-year process avoids pushing the owner into a higher tax bracket.

The risk of the multi-year plan is that the IRA might appreciate significantly over the years so that the eventual taxes, even at the 25% rate each year, are greater than taking the full hit in the first year. To reduce this risk, the IRA should be reconverted as soon as possible in the year after the first conversion. Another risk of the multi-year conversion is that Congress might increase tax rates.

The most common reason to recharacterize an IRA is that the value of the IRA declined. The value of a converted IRA should be monitored right up to the deadline for recharacterization. If the value declined significantly and seems likely to remain near the lower value for a little while, recharacterize the IRA and plan to reconvert in the future at or near the lower value.

Before beginning a conversion plan, check the fees charged by the IRA custodian. Some will charge for each conversion and recharacterization. Also, be sure the custodian does not impose restrictions in addition to those of the IRS.

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