Recharacterize IRA after market plunge

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Dear Dr. Don,
I converted my traditional individual retirement account to a Roth in March 2008 and it is entirely invested in one mutual fund. Since the conversion, the value of my Roth has decreased from $17,635 in March to $10,985 in November.

I realize that I could undo the conversion, but I’m worried that the market could rebound before I can reconvert back to a Roth 12 months later. I’m 27 years old and can pay the taxes on the conversion without tapping my IRA. What would you recommend given my situation?
— Daniel Do-over

Dear Daniel,
A key assumption is that this conversion was done for the 2008 tax year. Your 2007 tax return should help clarify if this was the case. Review your tax return if you’re unsure.

If you did the conversion for the “2007” tax year, you’re past the point where you can recharacterize the conversion. Otherwise, read on.

Taxes on the Roth IRA conversion are based on the value at the time it was converted. Assuming you’re in the 25 percent marginal federal income tax bracket, if you don’t recharacterize the Roth IRA, you’ll owe about $4,400 in tax. Recharacterize the conversion as a traditional IRA and you won’t owe the taxes. 

You’re right that by doing the recharacterization, you’ll have to wait to reconvert to the Roth IRA. IRS Publication 590, “Individual Retirement Arrangements,” provides an example that matches your situation and explains the horizon for reconverting to a Roth IRA:

If you convert an amount from a traditional IRA to a Roth IRA and then transfer that amount back to a traditional IRA in a recharacterization in the same year, you may not reconvert that amount from the traditional IRA to a Roth IRA before:

  • The beginning of the year following the year in which the amount was converted to a Roth IRA.
  • Or if later, the end of the 30-day period beginning on the day on which you transfer the amount from the Roth IRA back to a traditional IRA in a recharacterization.

I don’t understand why you’d be willing to pay $4,400 for the privilege of keeping the money in a Roth IRA. You’ve already taken roughly a 40 percent hit in the fund — and that ignores the tax impact. Why pile on another 25 percent?

A recharacterization would leave you worse off only if the fund’s value was above the $17,635 value of the first conversion. I’m no market prognosticator, but my guess is that you’ve got some time on your hands before this account sees that valuation.

You can reinvest the traditional IRA monies to capture any rebound in the market. Sure you’ll owe federal income taxes when you reconvert. But by the time you are eligible to reconvert, do you really expect the account will be worth more than the $17,635 it was worth this spring?

By the way, you should run all of this by your tax professional because there are details about your financial situation not presented here that could make a difference in your decision. These include the expected tax bracket you’ll be in when you have the opportunity to reconvert, as compared to your current marginal federal income tax bracket.