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Go Back In Time On Roth Conversion

Who says you can't go home again? If you recently converted funds in a traditional IRA into a Roth and the value of the account has declined, or you have other reasons for regretting the move, you can "recharacterize" the conversion. In effect, it's like it never happened. But a "return home" isn't automatically allowed. You must meet an IRS deadline.

Why would you convert in the first place? If you're in a high tax bracket and actively participate in an employer retirement plan, your contributions to a traditional IRA aren't tax deductible, and though you won't be taxed when you withdraw those contributions during retirement, you will owe taxes, at your ordinary income rate, on distributions of investment earnings from the account. The top current tax bracket is 39.6%, plus you may owe an extra 3.8% surtax on net investment income (NII). And, under the rules for required minimum distributions (RMDs), you must begin emptying your IRA in annual increments after age 70½.

In contrast, qualified distributions from a Roth that's at least five years old are 100% tax-free. The 3.8% surtax also doesn't apply. ("Qualified" means that the distribution was (1) made after age 59½, (2) made on account of death or disability, or (3) used for first-time homebuyer expenses, with a lifetime limit of $10,000.) Moreover, RMD rules don't apply to a Roth IRA during your lifetime. You can keep your account intact and pass it along to your heirs, who will be able to take lifelong, tax-free distributions. The only catch is that to make a conversion to a Roth IRA, you must pay tax on the amount you transfer, just as you would on a regular IRA distribution.

But what if the value of the converted account declines significantly? Suppose you converted $500,000 in an IRA to a Roth on January 1. If you're in the 39.6% tax bracket this year, the conversion tax is $198,000 (39.6% of $500,000). However, if the account value falls to $450,000, you've paid $19,800 more in tax (39.6% of the $50,000 difference) than you would have owed if you had waited to convert.

The tax law permits you to recharacterize a Roth back to a traditional IRA. You just have to meet the deadline for a recharacterization - the due date for your tax return for the year of the conversion, plus any extensions.

And if circumstances dictate that you change your mind again? You can reconvert your account back to a Roth, but you'll have to wait until the later of (1) the beginning of the tax year following the tax year of the conversion and (2) the end of the 30-day period beginning on the day of the recharacterization.