Retirement


A Mulligan for Roth IRA Conversions

EDITOR'S NOTE: This article was published in the February 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

With the income ceiling lifted this year, you may get caught up in Roth conversion fever. Not sure whether to go for it? No worries. If you convert to a Roth, you can change your mind and put the money back into a traditional IRA.

The reversal procedure, called recharacterization, gives you a little insurance against the conversion income-tax bill. When you convert to a Roth, you owe income tax on the value of the account at the time of the conversion. Without the ability to recharacterize, if the markets later sink, you'll get stuck with the double whammy of a lower account value and a tax bill on the original value.

Let's say your regular IRA is valued at $100,000 when you convert. A few months later, the account falls to $75,000. If you're in the 35% tax bracket, you'll owe $35,000 in taxes on the full $100,000.

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You could instead recharacterize and therefore avoid the tax bill on money that's disappeared. If you later reconverted the account at $75,000, you'd owe $26,250. "Recharacterizing could save you a lot of money," says Paul Jacobs, a certified financial planner in the Atlanta office of Palisades Hudson Financial Group.

Another reason to recharacterize is if you racked up more taxable income than you expected and the conversion boosts you into the next tax bracket. By recharacterizing, you remove the money from your taxable income, which drops you into the lower bracket.

For some who converted in 2009, a recharacterization may be necessary to avoid violating IRS rules. Say you had projected an adjusted gross income of $80,000 in 2009, so you did a Roth conversion, says David Hill, a financial planner for Brinton Eaton Wealth Advisors, in Madison, N.J. But, unexpected income pushed your AGI over the $100,000 income limit for a 2009 Roth conversion. To avoid trouble with Uncle Sam, you could recharacterize the conversion. (That $100,000 limit disappeared on New Year’s Day 2010.)

The IRS lets you do a recharacterization up to October 15 of the year following the year you converted. So if you convert in February 2010, you have until October 15, 2011, to reverse the conversion and avoid paying the tax bill.

For 2010 conversions only, you can elect to pay the tax bill on your 2010 return or defer it a year and split the bill over your 2011 and 2012 returns. If you want to undo a 2010 conversion for which you'd planned to defer and split the bill, the October 15, 2011, deadline still applies. It's best to pay the tax bill for the conversion using money outside the IRA. If you need to reverse the conversion and you paid the tax out of the IRA assets, the money can't go back into the IRA.

Set Up Several Roths

Consider splitting the conversion into multiple Roth IRAs -- one for each asset type. That gives you the flexibility to recharacterize only the Roths holding assets that have declined in value. "You can split your IRA as fine as you'd like," says Jacobs.

For instance, you might break up your IRA into Roths holding U.S. stocks, foreign stocks and bonds. Or you could split stock holdings into a Roth that holds shares of large companies and a Roth that holds shares of small companies.

Say your $200,000 IRA holds $100,000 in stocks and the rest in bonds. You can split those assets up into a stock Roth and a bond Roth when you convert. If later the stock assets sink to $70,000 but the bond assets grow to $120,000, you can recharacterize just the Roth that holds stocks.

There's no limit to how many separate accounts you can have. Keeping track of multiple accounts could spiral into a paperwork nightmare. But you can always combine the accounts after the recharacterization deadline is up.

Want to undo your do-over? If you recharacterize a Roth, you can always reconvert the money later. You just have to wait at least 30 days and until the beginning of the calendar year after the year of the original conversion.

For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger's Retirement Report.

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