The #1 Reason to Recharacterize Your Roth IRA

October 15 DeadlineHaving second thoughts about last year’s Roth IRA conversion? If so, you better act fast. If you converted a traditional IRA to a Roth IRA last year you have until October 15th of this year to undo it.

The IRS allows IRA owners who converted their traditional IRA to a Roth IRA to “recharacterize” or undo that Roth IRA, no questions asked. However, this must be done by October 15th of the year after the year in which the traditional IRA was converted to a Roth.

In English: if you converted an IRA to a Roth IRA last year, you have until October 15th of this year to undo the conversion and recharacterize the Roth IRA back into a traditional IRA.

Roth IRA recharacterization

In my opinion, the #1 reason to recharacterize a Roth IRA back into a traditional IRA is that you lost money! If the value of your IRA has dropped significantly, you should recharacterize back into an IRA.

Here’s why:

If your IRA was worth $100,000 at the time of conversion, you owe federal and state income tax on $100,000. That’s part of the deal when you convert an IRA to a Roth IRA. But what happens if the Roth IRA is suddenly worth a lot less? That’s when you want to recharacterize. And fast! Remember the October 15 deadline.

By recharacterizing back to the original IRA, the IRS treats the whole transaction as if it never happened. Your IRA is still an IRA. It’s just worth a little less.

For example

Let’s say you bought stock of your favorite company at $50 a share. In fact, your IRA owns nothing but this stock and you have 2,000 shares of it – $100,000.

In 2013, you converted your IRA to a Roth IRA. Now you owe tax on the $100,000 conversion – approximately $34,000 in federal and state income tax (more or less, depending on where you live and your tax bracket). The only problem is that the stock is now trading at $20 a share. Your newly converted Roth IRA is only worth $40,000. The tax on the conversion amount is almost that much.

By recharacterizing the Roth back into an IRA, you avoid the tax. Your IRA is still worth only $40,000. The IRS can’t help you there, but at least you’re not stuck paying a large tax bill on what is now a relatively small IRA.

Convert again in the future

If you are still intent on converting your IRA to a Roth IRA (which is usually a very good idea, by the way) you can still do so. Only this time, you will be converting a smaller IRA — $40,000 in the example above, not $100,000.

Since the tax due on your conversion is based on the value of your IRA at the time of conversion, your tax bill will be proportionately less. In this case, your tax bill might be closer to $12,000 rather than $34,000 – a tax savings of over $20,000! Then, when the value of your IRA eventually bounces back, it will all be tax-free.

If you have any questions about your IRAs, just ASK MIKE.