If you converted your traditional IRA to a Roth last year and are having second thoughts, there's still time to undo the conversion. But you need to act quickly or lose your opportunity to undo -- or recharacterize -- your Roth IRA back to a traditional IRA.
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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, or 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 IRS.
"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 redo 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. If you change your mind after a recharacterization, the IRS will allow you to convert your traditional IRA to a Roth IRA again, but you have to wait 30 days after the recharacterization or one year after the initial conversion, whichever is later, according to IRS Publication 590.
Here are the four steps you need to follow to undo your Roth conversion.
4 steps to undoing a Roth IRA conversion
1. Decide whether a redo makes sense or is necessary.
2. Talk to your Roth IRA custodian and fill out redo forms.
3. File an amended tax return.
4. Consider when to reconvert to a Roth.
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. Previously, Roth IRA conversion rules required that taxpayers making conversions meet certain income limits.
Under new rules that went into effect 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, disappeared 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 San Diego-based retirement services firm. "That lets you avoid penalties and all sorts of things. This is a nice availability that the IRS has afforded us."
2. Talk to your Roth IRA custodian and fill out redo forms. Once you've decided to undo the conversion, your first step should be to pick up the phone and talk to your Roth IRA custodian, which is usually a bank, brokerage, mutual fund or some other type of financial services firm. Customer service representatives or retirement planning specialists can walk you through the specifics of how to undo the conversion and recontribute the money to a traditional IRA.
"Typically, brokerage firms or mutual fund companies have premade forms, so all you have to do is ask them for the form and fill it out and send it in, and they will recharacterize it for you," says D'Italia.
Your financial services company will generally ask you for the account numbers for the Roth IRA and traditional IRA account that the funds need to be moved to and from, the date on which the initial conversion was made and the amount of any Roth investment gains. If you don't want to redo your entire conversion, you can choose to recharacterize part of it. In that situation, you need to specify which assets from which accounts you want to redo, should you have more than one Roth IRA account.
"Do your homework and work with a custodian that knows what they're doing so that all the i's are dotted and the t's are crossed," says Wagner. "If you do that, I think you're in good shape."
3. File an amended tax return. When you redo a conversion, you must file Form 8606 along with your amended tax return, the 1040X, says McCabe. The financial services institution that serves as custodian of your account will send you two Form 5498s that will show the amount of the conversion and the amount of the recharacterization, which you or your tax adviser will use to prepare your amended return.
The amended return must be filed by Oct. 15 for the tax year in which you converted, says Wagner. If you wait until after Oct. 15, IRS rules don't allow you to undo your conversion, so you will just have to live with it.
Your original 1040 form shows the amount of tax you paid on the conversion. When you file the 1040X, you'll figure out how much interest the IRS owes you on your refund for the tax that you already paid, Wagner says.
4. Consider when to reconvert to a Roth. Odds are, if you converted to a Roth IRA in the first place, it's a retirement investment you want. So once you get past the IRS imposed waiting period -- 30 days after recharacterization or one year after conversion, whichever is later -- you are free to convert again. If you convert in 2010, the IRS gives you a two-year window to pay your taxes.