Jason Dinesen

Jason Dinesen

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Technical Tax Tuesday – How to Do a Roth Recharacterization

EDITOR’S NOTE:  Technical Tax Tuesday is a monthly feature published on the second Tuesday of each month in which Jason will go in-depth and work through a tax situation.  If you have a topic you think would be a good fit for Technical Tax Tuesday, please e-mail Jason at dinesentax@gmail.com.

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Roth conversions have been popular over the last year or so.  You may have even done a Roth conversion yourself.  Did you know you can “undo” a Roth conversion?  You can, in a process called a Roth “recharacterization”.  This article will cover how to do it.  (Note:  this only applies to IRAs.  If you did a Roth conversion within a 401(k) plan, you cannot reverse it.)

Background — What is a Roth conversion?

There are two types of Individual Retirement Arrangements (IRAs):  traditional and Roth.

When you put money into a traditional IRA, you can take a tax deduction (if your income is within certain limits).  Earnings grow tax-free.  You are taxed when you withdraw money from the IRA.

Roth IRAs work differently.  Money you put into a Roth IRA is not tax deductible, but withdrawals from a Roth account are tax-free if you are over age 59 1/2 and have had the account for at least 5 years.

It is possible to convert a traditional IRA into a Roth IRA.  The process is rather simple.  You simply move the traditional money into a Roth account.  On your tax return, you claim the value of the traditional money on the date of conversion as taxable income.

Example 1
In 2011, you convert your traditional IRA to a Roth IRA when your account balance is $50,000.  You will claim $50,000 as income on your 2011 tax return.

How Can You Undo a Roth Conversion?

Here are two reasons why you might want to undo the conversion:

  1. The account value drops significantly after the conversion.
  2. You find that you can’t afford to pay the taxes on the conversion.
Once you’ve decided to undo the conversion, here are some things to consider:
  1. Timing.  You have until the extended due date of the tax return for the year the conversion initially took place.  So if you did a conversion in 2011, you have until October 15, 2012, to do a recharacterization.
  2. The recharacterization must be done as a trustee-to-trustee transfer.  Meaning, it has to be a direct transfer from the Roth IRA to the traditional IRA.  You can’t have a check written to you which you then deposit into the new IRA.
Next, you have to calculate the gain or loss that happened from the date of the conversion through the date of the recharacterization.  IRS Publication 590 provides a worksheet to help with the calculation, or you can refer to Treasury Regulation 1.408A-5.  This is simple if the Roth account was brand-new and no other deposits were made into the account.  In that case, you just transfer the Roth account back to a traditional IRA.
Example 2
Continuing with Example 1.  After you converted your traditional IRA to a Roth IRA, the value of your account drops to $40,000.  You don’t want to pay taxes on the $50,000 of the conversion, so you decide to recharacterize the Roth IRA back to a traditional IRA.  Because the Roth IRA account was new at the time of the conversion, you simply transfer the $40,000 back to a traditional IRA.  The $50,000 conversion is considered reversed.  If this takes place in 2011, there is no tax impact.  If the recharacterization takes place in 2012 after you had filed your 2011 tax return, you will have to go back and amend the 2011 return.  At any rate, the recharacterization must be done before October 15, 2012.
If the Roth IRA had an existing balance or you made other deposits into the account after the original conversion, it gets more complicated.  You have to do calculations to figure how much gain or loss should be allocated to the original conversion amount.  I’ll tackle that issue in next month’s edition of Technical Tax Tuesday.
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