If you converted your traditional individual retirement account to a Roth last year and are having second thoughts, there's still time to undo the conversion and get a refund of the taxes you paid. With the Oct. 15 deadline approaching, you need to act quickly or lose your opportunity to undo -- or recharacterize -- your Roth IRA back to a traditional IRA.
Recharacterization is fairly straightforward, but it entails enough work that you should first be sure that undoing your Roth conversion is worth it. You may seek to undo your initial conversion for several reasons:
- The value of your Roth IRA account is substantially lower than when you made the conversion.
- You weren't eligible for conversion but converted anyway.
- You are in a difficult financial situation and now need the money you spent in taxes.
Taxes due on conversion can be substantial because you must pay tax on the entire value of the amount you converted, unless you had nondeductible contributions within the converted funds.
This is because you generally make contributions to a traditional IRA on a tax-deductible basis, while Roth contributions are made on an after-tax basis. So if you converted during the 2008 tax year, you were required to pay the taxes due on the conversion with your 2008 tax return. If you undo the conversion, you will get a refund for any tax you paid plus interest from the Internal Revenue Service.
"A major reason why you might want to recharacterize is if you converted your traditional IRA to a Roth in 2008 and your balance was $50,000, but then the market started to fall, and your balance is now $30,000," says Jeff D'Italia, a senior financial professional with Firstrust Financial Resources, a wealth management firm in Philadelphia. "Even though the value is down, you still have to pay taxes on the amount you converted. So you are recharacterizing because you want to get a refund on the taxes you paid on that higher amount. That's the optimal situation -- to recharacterize the Roth because the value is lower now."
Should you decide to undo a Roth conversion, you need to remember that you lose the benefits of a Roth IRA. Such benefits include tax-free compounding of investment gains and no required minimum distributions upon retirement.
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Here are the four steps you need to follow to undo your Roth conversion:
1. Decide whether a redo makes sense or is necessary. If you're considering undoing your Roth conversion because you paid taxes on contributions and gains that have disappeared as the market has fallen, you should make the move if the investment losses were substantial. If you lost a few thousand dollars after the conversion, it's probably not worth it because of the time involved to undo the conversion and because the amount of tax you paid isn't significant.
For example, if you converted a traditional IRA worth $10,000 to a Roth and after the conversion the value of your Roth fell to $8,000, your refund upon submitting your amended tax return for the recharacterization would be $500 if you were in the 25% tax bracket, plus any state and local taxes.
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On the other hand, if you converted a Roth that was worth $100,000 and lost $20,000, your refund upon filing an amended return would be $5,000 if you were in the 25% tax bracket, plus any state and local taxes. That is large enough to be worth the hassle of converting, says Tom McCabe, certified public accountant and director of accounting for Prestige Wealth Accounting Group in Pennington, N.J. Your tax adviser can help you decide if a redo makes sense.
A redo because of investment losses is optional, as is a redo if you lost your job and need the tax refund to pay your bills, McCabe adds. But a redo isn't optional if you made a mistake about your eligibility to convert and converted when you weren't eligible. Current Roth IRA conversion rules require that taxpayers making conversions meet certain income limits.
Under new rules that go into effect on Jan. 1, 2010, you can convert to a Roth IRA even if you file as married, filing separately. And the income limits that prevented many taxpayers who earned more than $100,000 from converting in the past disappear on that date as well.
"If you converted your IRA into a Roth and you found that your adjusted gross income was in excess of $100,000 and you couldn't do it, the IRS allows you to reverse the mistake," says Jim Wagner, president of Trust Administration Services, a retirement services firm in San Diego. "That lets you avoid penalties and all sorts of things. This is a nice availability that the IRS has afforded us."
Continued: A retirement investment you want
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