Reversing a Roth IRA Conversion

Summary Points

• A conversion from a traditional IRA to a Roth IRA can be reversed through a process known as recharacterization.
• Investors may want to consider recharacterizing if a conversion from a traditional IRA to a Roth IRA increases their marginal tax rate.
• Because recharacterization triggers a tax payment, investors considering this strategy may want to consult a tax professional to make sure they understand the tax issues.

As a volatile stock market continues its ups and downs, many investors facing losses are searching for appropriate strategies. Retirement investors may want to examine converting a traditional IRA to a Roth IRA, with the understanding that the conversion can be reversed if needed.¹

Why Now

Thanks to legislation that took effect in 2010, investors at any level of income can convert a traditional IRA to a Roth IRA. A choppy market can be an excellent time for those considering a conversion to take the plunge.

• A conversion triggers a tax bill on the amount of money that is converted, so a smaller account balance results in a smaller tax bite.
• Many observers believe that federal taxes are likely to increase in the years ahead as the federal government grapples with budget problems. Currently, qualified withdrawals from Roth IRAs after age 59½ are tax-free, which presents an important benefit for retirement investors.

Before deciding whether a conversion makes sense for you, make sure you understand the differences between a traditional IRA and a Roth IRA, which are explained in IRS Publication 590. Also consult an accountant to help you calculate the corresponding tax bill that may result from a Roth IRA conversion. Financial advisors usually recommend that taxes associated with a Roth IRA conversion be paid from assets outside of the Roth IRA account so as not to disrupt retirement savings.

There's a Redo

If you convert from a traditional IRA to a Roth IRA and you subsequently change your mind, you can move the assets back to a traditional IRA through a process known as recharacterization. TD Ameritrade can handle this transaction for you, and you will be required to file an amended tax return. There are several reasons why an investor who converts assets from a traditional IRA to a Roth IRA may want to consider a recharacterization, among them:

• The conversion from a traditional IRA to a Roth IRA may increase an investor's marginal tax rate. (Consulting a tax advisor in advance could help determine whether this situation applies to you.)
• The investor may not have enough cash on hand to pay the taxes.
• The investor may have changed his or her mind.

Note that the IRS does not specify these reasons. According to current tax rules, an investor does not need to present a reason for recharacterizing.

What You Need to Know

Recharacterization needs to be complete by the last date when federal taxes, including extensions, are due. This date is usually in mid-October of the following tax year. (For example, a Roth IRA conversion for the 2011 tax year needs to be recharacterized and an amended tax return filed by mid-October 2012.)

Some investors maintain multiple IRAs and undertake multiple recharacterizations as a tax management strategy. This process is very complex and should be undertaken with guidance from a tax professional.