4 Roth recharacterization considerations

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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.”

Consider the 2-year tax deal

The law change that eliminated the income restriction on traditional-to-Roth IRA conversions also gave taxpayers two years to pay any due taxes on the change as long as the conversion took place in 2010.

You can pay taxes on half of the converted IRA money on your 2011 taxes and the remainder on your 2012 return. But if you recharacterize the 2010 IRA conversion, says CPA Ed Slott, the two-year tax payment deal is dead.

If you later decide to convert to a Roth, all the taxable conversion income must be reported and paid in the tax year in which the move is made, says Slott, publisher of Ed Slott’s IRA Advisor newsletter.

Depending on your other income factors, spreading the taxes over the 2011 and 2012 tax years could reduce the amount of tax owed, says Slott. So keeping the Roth converted in 2010 might offer the least tax costs.

Wait until the last minute

The conventional tax wisdom is not to delay filing until the ultimate deadline. Throw out the conventional wisdom when it comes to a Roth recharacterization.

Stock market watchers are well aware the market can change dramatically and quickly. An IRA can lose much of its value one day and recover it the next.

Taking as much time as possible before making any irreversible recharacterization is generally a good idea. For 2010 conversions, that means you have until Oct. 17 since the regular deadline falls on a weekend.

But don’t wait until that date to decide; do it the week before.

You can’t move the money back to a traditional IRA yourself. The change must be trustee-to-trustee. And unlike your tax return that is considered filed on time if it’s postmarked on the deadline day, a Roth recharacterization must be completed by the deadline.

Check with your IRA custodian about specific policies and procedures to ensure that your Roth recharacterization will be processed in time, says Slott.

Think long term

While you’re taking as much time as allowed to decide about recharacterization, also evaluate your overall retirement savings plan.

“You can’t react to day-to-day market activity,” says Slott. “Going tax-free with a Roth is forever. There are going to be ups and downs.”

So don’t overreact to market gyrations.

“You’ll drive yourself crazy and then you’ll probably make a bad move,” says Slott. “You’ll kick yourself if you try to time the market. Retirement savings is a very long-term proposition.”