Need to Undo a Self-Directed Roth IRA Conversion? Consider These Factors First.

Let’s first be clear on what we’re talking about here. In 2010, the IRS rules were amended to allow anyone, regardless of their level of income, to convert their traditional accounts to Roth accounts. This lets the account holder leverage all of the advantages that a Roth self-directed IRA has over a traditional account, even if they aren’t eligible to contribute to a Roth IRA directly.

But even though converting from a Roth IRA to a Traditional IRA is often a good financial decision, the timing of that conversion can sometimes mean that the taxes you pay upon conversion could be more than you would have paid if you had done the conversion at a different time.

If you find that you’ve done a conversion that could have been done for a lower tax hit if you had converted later, then you can undo or “recharacterize” that conversion, subject to a few requirements and considerations.

What is a Recharacterization? A “recharacterization” is the process of undoing a traditional to Roth self-directed IRA conversion that we just discussed. Why might a person want to undo the conversion? The most likely reason is that the value of the assets that were converted to their Roth IRA have fallen in value. This is significant because converting from a traditional IRA to a Roth account is a taxable event, so the larger the amount of the conversion, the larger your potential tax bill.

The Financial Case for Recharacterization. For example, let’s say you convert a traditional IRA valued at $200,000, with all of your contributions having been tax deductible. At a 30% tax rate, your nominal tax bill — paid with funds separate from the account you’re converting — is $60,000. Now let’s assume that the investments in your account decline in value by 15%. Your converted account is worth $170,000.

However, if you had converted after the decline in investment value, your tax bill would only be 30% of $170,000, or $51,000. This is a 15% savings (equal to $9,000) of the $60,000 tax bill you would have faced with the earlier conversion. By doing a recharacterization you can undo the conversion and have those funds go back into a traditional IRA, and avoid the higher tax bill.

Note that it’s also possible to recharacterize funds that you rolled over from an employer-sponsored retirement plan (such as a 401(k)) into a Roth. But in that recharacterization, the funds must go into a new or existing traditional IRA, and not back into the employer-sponsored plan.

Deadline for Recharacterization. Not surprisingly, you only have a limited period of time after making a Roth conversion to decide to undo or recharacterize it. In general, you can recharacterize an IRA conversion prior to October 15 of the following year, even if you filed an extension for your tax return.

Waiting Period Before Future Conversions. So what happens if, after a conversion and recharacterization, your investments increase in value again, and you’d like to do another conversion? The short answer is that you’re free to do so, but you may have to wait. More specifically, after a recharacterization you may only convert until the later of (a) 30 days after the recharacterization, or (b) the year following the year of the conversion.

The process can be a bit confusing if you’ve never done it before, so contact your IRA custodian or Quest Trust Company for more information.

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