Undoing a Roth Conversion
When converting a traditional individual retirement account (IRA) to a Roth IRA, transferred amounts must be included in income if taxable when withdrawn (e.g., contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10% federal income tax penalty. Your adjusted gross income (AGI) cannot exceed $100,000 in the conversion year, excluding any converted amounts.
To use this strategy effectively, you need to decide when to convert. Taxes are paid based on your investments’ values on the conversion date. If those values decline after you convert, you end up paying taxes on more than the current market value.
If you’re in that situation, consider recharacterizing your conversion. For conversions made in 2007, you can recharacterize until October 15, 2008, meaning you can convert back to your original traditional IRA. Just make sure not to take possession of the funds. The transfer from the Roth IRA to the traditional IRA should be a trustee-to-trustee transfer. After the recharacterization, it is as if you did not convert, so you owe no taxes. If you already filed your 2007 tax return and paid the taxes, you can file an amended return to get a refund. You can then reconvert at a later date, provided your AGI does not exceed $100,000 in the conversion year. (Keep in mind that starting in 2010 there is no income limitation for Roth IRA conversions.) The reconversion can be completed at the later of 30 days after the recharacterization or the beginning of the tax year following the first conversion.
You can recharacterize just a portion of the conversion. However, if you have several investments in the IRA, you can’t simply choose the ones with the largest losses. In that situation, a pro-rata portion of all the investments in the account will be considered in the recharacterization. You can bypass this rule by setting up separate Roth IRAs for each investment. Then, if one declines substantially, you can recharacterize that one Roth IRA account, leaving the other accounts intact.
There are other situations where you might want to recharacterize. You might have converted to a Roth IRA, thinking your income for the year would be less than $100,000. If you later find out that your income is over that threshold, you can recharacterize the conversion. Otherwise, in addition to the income taxes due, you would also have to pay a 10% federal income tax penalty and a 6% excise tax.
You can also recharacterize annual IRA contributions. Perhaps you contributed to a traditional IRA, but find your income is over the thresholds. You could recharacterize to a Roth or nondeductible IRA contribution.