4 Good Reasons to Consider a 'Do-Over' for Your IRA

At first blush, "recharacterization" might sound like the worst kind of Internal Revenue Service gobbledygook; as I type it, Microsoft Word doesn't even recognize it as a word. (Notice that I chose the much more user-friendly "do-over" for my headline.) But a recharacterization isn't as complicated as it sounds. Essentially, it's a way to undo an IRA that you might have opened or converted, enabling you to change a Roth IRA back to a traditional IRA or vice versa. Like tax-loss selling, recharacterizing can be a valuable maneuver to help some investors lower their tax bills.

There are a couple of key situations when a recharacterization can make sense, including the following:

Reason 1: You weren't eligible to contribute to that type of IRA. 
Say, for example, you opened a Roth IRA but determined your income was too high to contribute to one for that tax year. (Single filers who earned more than $122,000 in 2011 and can contribute to a company retirement plan can't make a Roth contribution for 2011; joint filers earning more $179,000 cannot make a 2011 Roth contribution, provided they can contribute to a company retirement plan.) In that case, you'd have to recharacterize your Roth IRA as a traditional nondeductible IRA, on which there are no income limits. If you chose to do so, you could execute a so-called backdoor IRA at a later time by converting those assets to a Roth account.

The opposite maneuver also works. For example, say you opened a traditional IRA but later found out your income was too high to allow you to deduct your contribution; in that case, you might be able to recharacterize your traditional IRA as a Roth. The income limits are even more stringent for traditional deductible IRA contributions than they are for Roths.

Reason 2: You converted traditional IRA assets to Roth but the tax hit associated with the conversion was bigger than you expected.
Conversions can push you into a higher tax bracket, exceed the amount of cash you have on hand to pay the tax bill, or both. In that case, your best bet might be to recharacterize back to a traditional IRA and stand pat. Or better yet, you could recharacterize and then do partial conversions in the years ahead, converting just enough of your assets to maintain a manageable tax load in each year, thus keeping you from bumping into a higher tax bracket. Just bear in mind that if you're converting after a recharacterization, you'll have to wait 30 days after the recharacterization or at least one year following the original conversion, whichever is later. To further complicate matters, it's also worth noting that you can do partial recharacterizations, shifting some of your Roth assets back to a traditional account but leaving some money intact in your new Roth IRA.

Reason 3: You executed a backdoor IRA without fully understanding the tax implications.
In a similar vein, recharacterizations can provide a valuable escape hatch for those who triggered a big tax bill by converting a small traditional nondeductible IRA to Roth status while leaving other traditional IRA assets untouched. How can that happen? When determining your conversion-related tax burden, the IRS considers all of your IRA assets together, not just those that you've converted. Specifically, with each conversion, the amount you're taxed is based on the percentage of your total IRA assets on which you haven't yet paid taxes, such as any pretax contributions and investment earnings. Due to that rule (also outlined in this article), those who have large pretax IRA balances, especially with rollover IRAs, can unwittingly find themselves with larger-than-expected tax bills, even if they only converted a small traditional nondeductible IRA. A recharacterization enables you to circumvent those unwanted taxes by effectively assuming the conversion never happened.

Reason 4: Your account has declined in value since you converted your IRA.
Recharacterizations were particularly valuable during the bear market and might still come in handy for those with foreign- or financials-stock-heavy portfolios that have declined in value since they executed their conversions. That's because the tax you'll owe after a conversion will depend on your balance at the time you converted. If your account has slumped in value since you executed the conversion, you might be able to lower your tax bill by recharacterizing and converting when the markets are down. Just bear in mind the aforementioned time limits for conversion after recharacterization; if the market shoots up before you're eligible to convert again, you could lose your opportunity to convert at a more fortuitous time.

If you've determined that a recharacterization makes sense for you, you might also want to check with a tax or financial advisor to ensure that you're thinking through the variables and correctly assessing the tax implications. It's also worth noting that the amount you recharacterize doesn't have to equal your original contribution or conversion amount. If you contributed $5,000 to an IRA that's now worth $3,500, you would recharacterize the current amount. Filling out the recharacterization forms is straightforward; you can obtain them from the brokerage firm or mutual fund company where you hold your IRA assets. However, you'll also have to file an amended tax return after you've executed the recharacterization. Finally, stay attuned to the deadlines: For recharacterizations related to contributions or conversions made for the 2011 tax year, the deadline is the due date of your 2011 return, with extensions--Oct. 15, 2012.

See More Articles by Christine Benz

		30-Minute Money Solutions
	Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more.
	Get Your Copy Today--$16.95