Tue, October 11, 2011
Quite a few taxpayers did Roth conversions last year, taking advantage of the change in conversion eligibility rules. But for some of them, now might be the time for a do-over.
One of the interesting provisions of the tax code is the ability to do something called a recharacterization: funds converted into a Roth can be un-converted back into a traditional IRA. Why might you want to do a recharacterization?
The most likely scenario would be something like this: Assume that you converted $100,000 into a Roth last year and were in the 33% tax bracket. Converting gave you a 2010 tax liability of $33,000. But also suppose that now, owing to the vagaries of the financial markets, the $100K that you converted last year is only worth $60K. You might feel that $33K was a heavy price to pay, since it’s 55% of what you now have in the account. The recharacterization rules allow you to move the funds back into a traditional Roth account, file an amended return, and get your $33K back.
A key point here is that the funds that you’re transferring back do not have to equal the same amount as the original conversion. This confuses some people, but the point is, in the example given, the $60K constitutes all of the money that was initially converted – so only those funds have to be recharacterized.
The recharacterization deadline for most 2010 conversions is October 17, 2011 (October 15 is a Saturday, so it defaults to the following Monday), although you should confirm that it applies to your situation.
Here are some important points to remember about Roth IRA recharacterizations:
In order to do a Roth recharacterization properly, you must make a direct transfer of funds from the Roth IRA to a traditional IRA. You cannot recharacterize by withdrawing the funds from the Roth and then depositing them.
Even if the Roth conversion was done from a qualified retirement plan (like a 401(k)), the recharacterized funds must be transferred into a traditional IRA.
The recharacterized funds don’t need to go back into the same IRA from which they came; they just need to go into a valid traditional IRA.
You’re allowed to do a partial recharacterization. In the example given above, recharacterizing $30,000 of the funds would eliminate the tax liability that you owed for half of the original conversion amount.
Once you have recharacterized a Roth conversion, you’re not allowed to do another Roth conversion and move those funds out again into a Roth until either the tax year following the year of the original conversion, or 31 days after the recharacterization, whichever is later.
Finally, keep in mind: Doing a recharacterization may or may not be a wise move for you personally. You should always consult a tax or financial advisor if you don’t have sufficient knowledge of the tax laws to determine accurately the financial impact of a recharacterization. There are ways to goof this up if you don’t understand the rules.