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.
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 percent tax bracket, plus any state and local taxes.
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 percent 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.
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