Tax Savings from Roth IRA Recharacterization

9/30/2010

By Mark Corey, CPA

This year saw a flurry of people converting their regular IRAs into Roth IRAs because of favorable tax rules that removed the income limitations, and also allowed payment of the tax on conversion to be paid over the following two years, 2011 and 2012.

However, there are times when this conversion may not have been a good idea. In cases like these, the IRS allows a taxpayer to “undo” the conversion. One of the situations that may prompt an individual to consider undoing this conversion is a dramatic drop in the value of their portfolio converted into a Roth. The reason for this is that the tax owed on conversion is based on the value of the portfolio at the time of conversion, not the value at the time the tax is owed. For example, if you converted your traditional IRA with a value of $200,000 to a Roth IRA on December 31, 2010, and then filed your 2010 tax return on April 15, 2011, when your portfolio was worth $150,000, you would still owe tax on $200,000 of income at your marginal rate. Another reason to undo the conversion is a change in financial position that requires recouping the tax paid on conversion of the IRA.

If you chose to unwind the conversion to a Roth IRA, the tax code gives you until the extended due date for filing the tax return of the year you made the conversion. In this example, the deadline to recharacterize a Roth IRA back to a traditional IRA and reclaim any taxes paid on the conversion would be October 15, 2011 (with an extension). If you wait for a certain period of time after you unwind the conversion you can reconvert back to a Roth IRA. If the re-conversion took place in 2011, you would forgo the provision that allows payment of the tax over two years, but in the example above, you would save tax on the $50,000 of lost value.

The rules related to a conversion of a traditional IRA to a Roth IRA are complex and worthy or serious consideration before making the decision to convert. But it is good to know that if you make the decision to convert your traditional IRA to a Roth IRA, you can undo that conversion if needed.