NEW BERLIN, Ill. (MainStreet) -- Last year a large number of folks took advantage of an option newly available to them by converting IRA funds to a Roth IRA. The conversion had not been available to folks with an income above $100,000, but the law was changed to allow folks with any income. In addition, for last year only, when you converted you had the option to delay paying tax until the following two tax years.
Since the market has taken a downturn in recent months, there now are a great many folks who may be looking to "undo" a conversion. The rules generally allow you to do this until Oct. 15 of the year following the conversion (it's actually Oct. 17 this year). This "undo" activity is known as recharacterization.
You might want to recharacterize your conversion if your investments in the Roth plan have gone down in value. If this is the case, you would be paying taxes on more money that you converted, making the tax cost of the conversion much higher than you thought. This recharacterization is a one-time option that allows you to put the money back in the traditional IRA where it started and wipe the slate clean -- as if you didn't do the conversion at all.
For example, let's say you converted $100,000 from your traditional IRA to a Roth last year. When you filed your tax return this year, you opted to pay the tax on your 2011 and 2012 returns. Now the investments you made in your Roth IRA have declined in value to $50,000. Instead of paying taxes in 2012 and 2013 amounting to as much as $35,000 on this conversion, you can recharacterize and have no tax owed -- because as far as the IRS is concerned, it never happened!
To determine if you need to (or want to) recharacterize a conversion, you need to make sure you understand the net value of your converted amount -- this means you consider the amount you're converting, plus any capital gains, dividends and interest and subtract capital losses and fees. If your account is a net negative, or if any investment you've made in the account is negative, you probably want to recharacterize.
It's not an all-or-nothing proposition. You could recharacterize a portion if the circumstances warrant.
To start things off, you contact the custodian for the new Roth account and the old traditional IRA account to let them know you're recharacterizing. Then you move the net amount of the conversion after gains and losses are applied (described above) back into the traditional IRA. You have to complete this by Oct. 17 for conversions completed last year.
If you have already filed your tax return for 2010, you will want to file an amendment so you can eliminate the reference to the conversion. You have until April 15 of 2014 to file the amendment, but to avoid confusion with your next two returns you probably want to do this as soon as possible.
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