Do-Over for a Roth Conversion
October 15 is the deadline to change a Roth back to a traditional IRA — and get back the money you paid in taxes on the conversion.
I converted my traditional IRA to a Roth in 2012, thinking it would be a good time to make the move in case taxes increased a lot in 2013. Tax rates didn't go up, so I'm wondering if I can undo the conversion and get back the money I paid in taxes, then spread the conversion over several years.
You have until October 15, 2013, to undo a Roth conversion made in 2012. The process is called "recharacterization," and once you move your money back into a traditional IRA, you can file an amended return and get back the money you paid in taxes on the conversion. As long as you wait 30 days after the recharacterization, you can reconvert any or all of the funds to a Roth when you decide the time is right.
Michael Goodman, a CPA and personal financial specialist in New York City, says recharacterizing makes sense if your tax bracket is lower — as it might be if you got laid off, for example. Then you can reconvert at the lower tax bracket.
It can also make sense if your investments lost money after you made the conversion. "If I converted when the IRA was worth $10,000 and it's now worth $6,000, it makes sense to unconvert," says Goodman. If you then reconvert the lower amount, you'll owe less tax.
But if your investments have appreciated, even if your tax rate is lower than it was last year, recharacterizing and later reconverting could cost you more, says Maria Bruno, of Vanguard's Investment Strategy Group. That's because you have more to reconvert. If you leave the Roth alone, any growth in your investments since you converted is tax-free.
Look at the total cost of the conversion — considering your tax bracket and the value of the investments — when deciding whether the switcheroo is worthwhile. If the math is pretty close, keep the conversion rather than recharacterizing, says Goodman. "People tend to get overfocused on what they paid this year or will pay next year in taxes, but they need to keep their eye on the bigger long-term picture." They may recharacterize and then not be in a position to convert the account again — and end up losing the long-term benefits of the Roth's tax-free growth.
If you decide to recharacterize the account, the process is pretty simple. At Vanguard, for example, clients generally request a recharacterization over the phone. If you own only Vanguard mutual funds in the account, you don't need to complete any paperwork. If you have brokerage securities and non-Vanguard mutual funds, you can call to initiate the change but you must also complete a recharacterization form, which you can fax back. Vanguard does not currently process recharacterizations online.
You can recharacterize any portion of a conversion. The recharacterized amount will be adjusted for any gain or loss incurred while you are invested in the Roth.
To reconvert assets to a Roth, you must wait at least 30 days and until the beginning of the year following the year of the original conversion. If you're recharacterizing a 2012 conversion, you just have to wait 30 days to reconvert, since you've already passed the "following year" test. It's permissible to divide IRA assets and convert to several separate Roth accounts, each invested in different kinds of assets. That way, if one asset class falls in value, you can recharacterize that account while allowing profitable Roth investments to continue to grow tax-free.
If you're recharacterizing a 2012 conversion, you'll need to file an amended tax return (Form 1040X). Goodman recommends including a letter making it clear why you're filing again. Keep in mind that you must meet the October 15, 2013, deadline for recharacterizing a 2012 Roth conversion even if the government is still shut down. (The IRS will check the date of the transaction when it processes the amended return.)
You'll get two tax documents from your IRA administrator to keep in your files: a 1099-R reporting the distribution of the funds from the Roth IRA (usually mailed by the end of January of the year following the recharacterization) and a Form 5498 reporting the deposit of funds into the receiving IRA (usually mailed by the end of May of the year following the recharacterization).