Deadline Nears for Reversing Your 2015 Roth IRA Conversion
Consider these money-smart reasons to undo a move into a Roth IRA.
Few times in life do you get a do-over. But with a Roth IRA conversion, you get a chance to rewrite history. It's not an unlimited opportunity: You have until mid-October of the year following the conversion to reverse it. For a 2015 conversion, the deadline is this coming October 17. It's an amazing tool that people often overlook, says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill.
But not retired orthodontist Dave Pesavento, 68, of Sugar Grove, Ill. He has done multiple conversions from his traditional IRA to Roth IRAs since 2010, and he considers reversing (or recharacterizing) each one at least twice -- the first time toward the end of the year he did the conversion to see if he needs to undo it to keep his tax bill in check. "I want to avoid the Medicare premium surcharge," he says, which is triggered if taxable income (including converted IRA assets) exceeds a certain threshold. He checks again the following year, as the October deadline approaches, to see if a conversion should be reversed because it lost value.
Out of the nearly 20 Roth conversions Pesavento has done in the past seven years, he has recharacterized twice: Once to keep his taxable income down, and the second time because the account's value had dropped.
A drop in value is generally the primary reason to undo a Roth conversion. You owe ordinary income tax on the value as of the date you move money from a traditional IRA to a Roth IRA. But "if you did a $50,000 2015 Roth conversion and it fell to $40,000 in 2016, it doesn't make sense to pay tax on $50,000," says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group, in Atlanta. Instead, recharacterize the conversion, putting the money back in the traditional IRA, and the conversion tax bill disappears. It's as if the conversion never happened.
Even if the overall market isn't down, check to see if your investment is. If so, you can extinguish the tax bill and claim a refund if you already filed your 2015 return. If you still want the Roth, reconvert the asset at its current value for a lower tax bill. You must wait at least 30 days after the recharacterization and until the year following the original conversion. Because it's already the next calendar year, you need to wait just 30 days to reconvert an undone 2015 conversion.
Manage Your Tax Bill
You may want to undo a conversion because of unintended tax consequences. Added to your taxable income, a conversion could push you into a higher tax bracket unintentionally, or cause Medicare premium surcharges to kick in or tax deductions to phase out. “There’s a big multiplication effect,” says JoAnn May, a principal at Forest Asset Management, in Berwyn, Ill.
And, says Jacobs, "it's not an all or nothing decision, you can do a partial recharacterization." If the conversion just slightly pushes you into the next tax bracket and the value of your Roth has climbed, trimming a slice of the converted amount could lower your tax bill while keeping most of the Roth growth intact.
May says she advised a client to partially recharacterize a conversion after the client received more income from inherited assets than expected. To avoid bumping into a higher tax bracket, May says, just a small portion of the conversion needed to be undone.
Planning ahead for a potential recharacterization can simplify your tax life. In a year you do a big Roth conversion, you may want to file for an extension for filing your tax return, putting the deadline off to mid-October -- the same deadline for undoing a Roth conversion. That way, you wouldn't have to file an amended return to retrieve your overpaid taxes if you did a do-over. "Anytime we do a conversion, we like to wait to do taxes until near October," Jacobs says.
You can also simplify the process by dividing a conversion into separate Roths by asset class. For example, you could set up a Roth IRA for stocks and one for bonds. Say the stock Roth gains value, but the bond Roth drops. You can reverse the bond Roth to wipe out the tax bill for that conversion. But you can keep the stock Roth, preserving its tax-free growth.