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individual retirement account (IRA) to a Roth IRA, transferred amounts must be included in income if taxable when withdrawn (i.e., contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10% federal income tax penalty. In 2009, your adjusted gross income (AGI) cannot exceed $100,000 in the conversion year, excluding any converted amounts. Starting in 2010, you can have any amount of AGI and still convert to a Roth IRA.
To use this strategy effectively, you need to decide when to convert. Recent stock market declines have lowered the cost of converting, since taxes are paid based on your investments' value on the conversion date. However, 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 2009, you can recharacterize until October 15, 2010, 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 2009 tax return and paid the taxes, you can file an amended return to get a refund. You can then reconvert at a later date. 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 in 2009 would be less than $100,000. If you later find out your income is over that threshold, you can recharacterize the conversion to avoid taxes and penalties. You can also recharacterize annual IRA contributions. Perhaps you contributed to a traditional IRA, but find your income is over the threshold. You could recharacterize to a Roth or nondeductible IRA contribution.
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