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Roth IRA Fall-Back: Re-Characterizing

A long-awaited tax law change provides a first-time opportunity for many wealthy retirement savers, who can now convert a traditional IRA to a Roth IRA regardless of income. The lure is the promise of future tax-free distributions or a bigger nest egg for your heirs. But what if you change your mind after you convert? You might well have second thoughts if the value of the assets you converted has dropped due to market conditions and you don’t want to be stuck paying tax on the higher value. In such a case, you may want to “re-characterize” a Roth back into a traditional IRA.

When you convert a traditional IRA to a Roth, you must pay tax on the conversion as if you had withdrawn the transferred amount from your IRA. But subsequent Roth distributions are completely tax-free if you’ve had the account for at least five years and you’re over age 59½. And, unlike a traditional IRA, which requires annual distributions after age 70½, a Roth allows you to leave your money in the account for as long as you like.

Prior to 2010, you could not convert to a Roth during a year in which your modified adjusted gross income (MAGI) exceeded $100,000. But this limit no longer applies. Plus, if you convert in 2010, you can split the taxable income evenly over the following two years (2011 and 2012). That sounds pretty good, but a problem may arise if the value of the assets plummets after the conversion.

Suppose you are age 60, earn $200,000 a year, and file a joint return. The assets in your traditional IRA are currently valued at $500,000. You decide to convert the entire amount to a Roth and choose the two-year tax deferral option. Assuming an annual 8% rate of return on your investments and a future 28% tax bracket, converting to a Roth will provide a “net benefit” of $451,000 after 25 years, according to a special Roth calculator for professionals.  

But suppose the stock market declines precipitously after the conversion. If the value of the assets falls to, say, $300,000, the net benefit of converting to a Roth will be reduced to $277,000. In that case, you might decide to convert the account back to a traditional IRA. The deadline for this re-characterization is your tax return due date for the year of the conversion. So you have until April 15, 2011, to undo a 2010 Roth conversion.

Can you convert to a Roth again later on? Yes. However, a traditional IRA generally can’t be reconverted until the start of the following tax year or until 30 days have passed, whichever comes later. The rules are meant to discourage people from flip-flopping between the two kinds of accounts. To avoid problems, please call for an appointment so that we can help you make the best choice for your circumstances.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.




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