Recharacterization

Ed Slott & Company

If you need to reverse a Roth IRA conversion, you need to do it now

Posted September 28, 2011

By Ed Slott & Company

Approaching as quickly as a Caribbean hurricane is October 17, 2011, the day of reckoning for undoing 2010 Roth conversions. A recharacterization means reversing your Roth IRA conversion as if it never happened. Once this date passes, most individuals who made 2010 conversions that they did not recharacterize will be irrevocably locked into them as well as their accompanying tax bills.

For individuals who have already lost substantial value on Roth conversions made in 2010 due to poor investment performance, the decision to recharacterize is often a no-brainer. Why pay income tax on market values that no longer exist?

You have until October 17, 2011 to recharacterize a 2010 conversion even if you have already filed your 2010 income tax return. You will have to file an amended return on Form 1040X (and also an amended state tax return, if applicable) to receive a refund of any tax paid on your conversion. The amended tax return must be filed no later than three years from the original due date (or extended due date) of your original return. Any income tax you already paid with IRA or Roth IRA funds cannot be added to the recharacterization amount.

You can do either a full or partial recharacterization. The mechanics are easy when it comes to a full recharacterization of a Roth IRA that holds only converted funds. You simply request a recharacterization of the original amount converted and the entire balance in the converted Roth account to be transferred to your traditional IRA and it’s done. Any gains or losses experienced in the Roth IRA carry over to the traditional IRA.

For a partial recharacterization, a net income calculation must be done on the entire account and the resulting gains and losses are apportioned to the recharacterization amount. The net amount is then transferred, trustee-to-trustee, back to the traditional IRA. You might want to consult with your financial advisor regarding this calculation and the documents required to do a recharacterization.

Assets that have undergone a Roth recharacterization can be re-converted to a Roth IRA, but only after a waiting period has passed. This waiting period is the later of:

a. More than 30 days, or b. January 1 of the year following the year of the original conversion.

New IRA funds can be converted at anytime.

You need to decide now if you are thinking about a possible Roth recharacterization. You’ll want to provide your IRA custodian with ample time to complete the transaction. There are very few, if any, opportunities in the tax code that allow you a second chance without penalty. And remember, unlike many school-yard games from your childhood, there are no longer “do-overs” when it comes to missing the Roth recharacterization deadline when the only reason for the request is that you changed your mind.

Ed Slott and Company has been called "The Best" source for IRA advice by The Wall Street Journal, and "America's IRA Experts" by Mutual Funds Magazine. Ed is a widely recognized professional speaker and author. Get more IRA information from America's IRA Experts.