The Error-Proof Portfolio: Undoing an IRA Conversion

This article originally appeared on Morningstar.com last year. In case you missed it, we're running it again as part of ourIRA Improvement Week.

The decision about whether to convert rests on myriad factors, the main one being whether you expect to be in a higher or lower tax bracket when you begin taking distributions from your IRA. A declining market, like the one we saw from late 2007 through 2009, can also make an IRA conversion a more attractive maneuver. That's because when you convert, you'll owe taxes on your investment gains and any deductible contributions you may have made. The smaller the investment gains, the less taxes you'll owe when you convert. 

And if you've already made a conversion and paid taxes when your account value was at a higher level, you too have a safety hatch. Taking advantage of what's called an IRA recharacterization, you can convert some or all of your IRA assets back to a traditional IRA, then convert back to a Roth at a later date.

To use a simple example, say you converted a $100,000 traditional IRA balance to a Roth and paid $25,000 in taxes because you were in the 25% tax bracket. If the account value subsequently drops to $75,000, you could recharacterize back to a traditional IRA, then convert again. But this time you would owe just $18,750 ($75,000 times 0.25) in taxes at the time of the conversion.

The same logic would also hold if you found yourself in a lower tax bracket than when you made the conversion. You could recharacterize back to a traditional IRA, then convert later on to take advantage of your lower tax bracket.

Mind the Fine Print
Your brokerage firm or mutual fund company should be able to coach you on the specific paperwork to fill out; you'll have to fill out a recharacterization form as well as a form for a new IRA.

That's all pretty straightforward, but there are a couple of wrinkles. First, if you have earnings on your initial Roth contributions, you'll need to recharacterize those as well--once you do the recharacterization, both your original contribution plus any investment earnings will now be part of your new traditional IRA. If you've lost money since you made your contribution--and that's not likely, given the market's trajectory during the past year--you'll just recharacterize the amount you have in the IRA at the time of the recharacterization, not the original contribution amount.

The other big wrinkle is time. The deadline for recharacterizing your IRA assets is the tax-filing deadline for the tax year in which you made the contribution, in this case, April 18, 2011. But you can take advantage of the IRS' automatic extension provision, giving you until Oct. 17, 2011, to recharacterize your IRA assets from Roth to traditional.

And if you decide to convert back to a Roth (after recharacterizing from Roth to traditional) you'd just need to wait until the latter of either the tax year following the tax year of the original conversion, for example 2011 for conversions made in 2010, or 30 days following the recharacterization.

A version of this article appeared on May 31, 2010.

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