Roth IRA Reversal Deadline is October 15


NEW YORK (MainStreet) — Taxpayers who converted their traditional IRAs into a Roth IRA but are now faced with a huge tax bill still have time to reverse or "recharacterize" the Roth IRA conversions from last year.

If you moved into a higher tax bracket because of the conversion or your Roth IRA's value dropped by a large percentage, you may want to consider reversing your conversion. The IRS deadline is October 15.

Roth IRAs are one of a few financial decisions where you can get a second chance. Consumers convert their traditional IRAs, which use pretax dollars, to Roth IRAs, which use after-tax income and grow the income tax-free.

One catch that many people forget – the accrued tax bill must be paid at the time of conversion. If your move was not timed well and your tax bill is larger than it should be, the IRS allows you to undo the conversion.

One prime example of when you want to reverse your conversion is when your portfolio drops substantially due to dips in the market. If you converted $100,000 of a traditional IRA to a Roth IRA, but the stock market tanks and now your nest egg is worth only $80,000, then you are you are stuck paying taxes on money you don't have, said Larry Rosenthal, ING retirement coach and independent financial advisor.

In this situation, you can reverse the Roth conversion to remove the tax liability, he said.

There is a catch though - once you file your taxes, you cannot reverse the Roth conversion. If you filed an extension, you have until October 15 to reverse the conversion.

In another scenario, your portfolio remains relatively flat or increases because of market changes. You are still required to pay taxes on the $100,000, but you already spent the money you allocated for taxes. If you are unable to come up with the money needed, you should reverse the conversion, Rosenthal said.

"To pay these taxes, you set money aside in a bank account," he said. "But, when the tax bill comes due, you find that life has intervened and you were forced to use the money for unforeseen expenses. If you can't pay the taxes, you should reverse the Roth conversion, but you need to do it before taxes are filed."

A Roth conversion can be a bad idea if an investor is at his highest tax bracket today and will be in a lower tax bracket when he is retired and the Roth IRA is distributing income, said Rich Linton, president, individual markets, ING U.S. Retirement.

"Saving for retirement is always a good idea," he said. "One of the fundamental planning aspects for Roth conversions or saving after-tax money in a Roth IRA is that if you anticipate, you will be at the same or higher tax-bracket when you need income from the Roth IRA versus your current tax-bracket."

Avoid a conversion if you will move up into a higher tax bracket, said Rosenthal. Instead, do a series of smaller conversions annually so you are not jeopardized at tax time.

"A conversion is a bad idea if it pushes you into a higher tax bracket," he said. "This is like measuring once and cutting twice. You want to be careful to convert only enough to stay within the same tax bracket, continuing to convert smaller amounts each year. Don't create tax bracket creep for yourself through a conversion."

Consumers can also set up their Roth conversions in separate investment classes such as small cap, large cap, emerging markets or bonds, said Ted Sarenski, CPA and CEO of Blue Ocean Strategic Capital in Syracuse, NY. You can always reverse them later if the market changes and those asset classes are devalued.

Consumers should consider investing in a Roth IRA regardless of what tax bracket they are in, because the distributions are beneficial to everyone, said Linton.

"There is a myth that Roth IRAs are generally beneficial for high net worth and high income individuals," he said. "While Roth IRAs are beneficial to this group, it is equally beneficial to middle America. Roth IRA distributions, which complement Social Security income, can provide an efficient stream of retirement income for individuals within the current 10%, 15% and 25% federal income tax brackets."

Investing in a Roth IRA directly is a great idea for younger people, because they have the greatest amount of time for the investment to grow tax free, said Sarenski.

"Congress may change the tax laws and not allow Roth IRAs to be added to in the future, so take advantage of this while you can," he said. "It is always a good idea to have a pool of pre-tax money and after-tax -- or tax free like the Roth -- to have flexibility in the future to draw from both pools to cover living expenses, yet keep the taxable portion to a lower or specific tax bracket."

Consumers should always make sure they set aside money to pay for taxes for a Roth conversion, Rosenthal said. The only sources the money should come from is a savings account, current cash flow or home equity.

"Don't take the tax money out of your investments or long-term savings," he said.

Tax savings is more about proper planning compared to tax reporting or compliance, said Mackey McNeill, CPA and CEO of Mackey Advisors in Bellevue, Ky. If you are not sure if your Roth conversion should be reversed, get some advice. Many CPAs charge by the hour and can give you accurate tax advice, she said.

"Finances are personal," McNeill said. "Always, always run the numbers on your specific situation. If you don't know how, seek help. The tax law is complex."

--Written by Ellen Chang for MainStreet

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