retirement

4 Roth recharacterization considerations

Highlights
  • If your account has swooned since your Roth conversion, you may want to undo it.
  • You'll lose the two-year window to pay taxes if you recharacterize a Roth.
  • Don't decide too early because the market may rebound.

If you went through the trouble of converting your traditional IRA to a Roth IRA last year, you may wish you could go back in time and undo the deed. In fact, you can undo it in a move that's known as a Roth recharacterization.

The doors to Roth individual retirement account ownership opened wide in 2010. That year anyone, regardless of income, became eligible to convert a traditional IRA, on which taxes are deferred, to a Roth account where eventual distributions will be tax-free.

Some Roth owners, however, are considering taking advantage of another, long-standing rule in connection with the retirement plan, which is the option to reverse the conversion in a Roth recharacterization.

A Roth account holder with second thoughts has until Oct. 15 of the tax year following the conversion year to put the money back in a traditional IRA. Because this coming Oct. 15 falls on a Saturday, the deadline is the following Monday, Oct. 17.

But before you start moving your retirement money around again, take a few minutes to make sure this redo is the right move.

Here are four things to consider before you recharacterize your Roth.

Figure out your recharacterization amount

A key reason to convert a traditional IRA to a Roth is to avoid paying taxes when taking distributions.

With a traditional IRA, taxes on earnings and deductible contributions aren't collected until you withdraw the money in retirement. But with a Roth IRA, your already-taxed contributions grow tax-free. There's no IRS bill when Roth funds are eventually distributed.

Because of the different tax treatments, you have to pay taxes on tax-deferred traditional IRA money moved to a Roth. That tax bill is based on the IRA's value at the time of the conversion.

If your Roth account's value is now substantially less than the amount you converted months ago, you will owe taxes on money you no longer have. Such losses are a key reason most people recharacterize a Roth.

But it doesn't have to be an all-or-nothing choice, says Jim Blankenship, CFP, owner of Blankenship Financial Planning in New Berlin, Ill. "Technically, you could have converted $100,000, but only $50,000 is in an asset that lost value, so you recharacterize just that portion that lost value."

If, however, your converted Roth does well but you have other reasons for wanting to recharacterize it -- say, for example, you don't have money from another source to pay the due taxes -- you must also send back any gains from the Roth account. "The trickiest part is to make sure that you have the value correct in the amount that you're bringing back to account for any earnings," says Blankenship.

Blankenship suggests moving traditional IRA funds into a separate Roth IRA when converting, rather than commingling it with another Roth. "It keeps the paperwork simpler," he says. "Just open a new Roth IRA and then roll it into a master Roth later, once you're sure you want to keep it."

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