How to Undo Part of a Roth Conversion

I read your How to Undo a Roth Conversion column , and I am considering this strategy. Can I recharacterize part of the Roth conversion, or do I need to undo the whole amount?

It is possible to undo just part of the conversion while keeping the rest of the money in the Roth. You have up to October 15, 2012, to undo a Roth conversion that was made in 2011 -- a process called recharacterization. Recharacterizing part of the money can be a good idea if your conversion would otherwise bump you up into a higher tax bracket or take you over the income limits for certain tax breaks or new taxes. For instance, the added amount could make you subject to the Medicare Part B and Part D high-income surcharge, which applies if your adjusted gross income (plus tax-exempt interest) is higher than $85,000 if you are single or $170,000 if you are married (see Medicare Premiums: Rules for Higher-Income Beneficiaries for more information). You could recharacterize just enough money in the account to drop you below those levels while keeping the rest of the money in the Roth IRA.

If you decide to use this strategy, contact your brokerage firm and specify how much of the conversion you’d like to recharacterize. The recharacterized amount will be adjusted for any gain or loss on the investment while it was in the Roth. You can then reconvert the money to a Roth and have it count as 2012 income. To reconvert, you have to wait until the calendar year after the original conversion and at least 30 days after the recharacterization, so you only need to wait 30 days if you recharacterize a 2011 conversion in 2012.

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Whenever you make a Roth conversion, consider breaking up the converted amount into a few separate accounts so that you have more control over which assets you recharacterize if some of your investments lose value. “You might have one account in large-cap stocks, one in small caps and one in bonds,” says Greg Rosica, a tax partner with Ernst & Young’s Personal Finance Services group. If the account invested in small-cap stocks loses money after you make the conversion but the two other accounts increase in value, you can recharacerize just the account with the small-cap stocks, get back the money you paid in taxes, then reconvert the small-cap stock account after 30 days (if you made the original conversion in the previous calendar year) and pay taxes on the smaller conversion.

Keep in mind, however, that keeping track of multiple accounts can be an administrative hassle (though there is no limit to the number of Roth accounts you can have), and they can be costly if you are paying separate fees for each account. See A Mulligan for Roth IRA Conversions for more information.