Whoa, that Roth IRA conversion you did last year seemed like such a great idea at the time didn’t it? I know I thought it was pretty wonderful. But things change and with the stock market tanking, your portfolio is probably not worth what it was back when you did the conversion. For some people, now might be a good time to – here’s the important IRS word: Recharacterize your IRA.
Basically, to recharacterize your IRA, you’re taking all the money that you “converted” and put it back into your Traditional IRA. You will need to talk with your financial adviser and fill out the proper forms to do this. You also have a deadline: you must complete the transaction by October 17th, so you don’t have a lot of time to work with here.
Once you recharacterize your Roth IRA, it will be like it never happened, so you’ll have to amend your tax return to eliminate the Roth conversion that you reported last April and claim a refund. But that might be the smartest tax move you ever made. Let’s take a look at an example:
Porky Pig is in the 25% tax bracket and he made a $10,000 Roth IRA conversion for tax year 2010. The cost of the conversion to Porky was $2500. But now, because of the stock market, Porky’s Roth IRA is only worth $8500. It’s like he paid $325 too much in tax. Is that enough for Porky to make a change? For me it is, but for some people it might not be.
Let’s take a look at Porky’s friend Bugs Bunny. Bugs did a larger conversion; he rolled over $50,000 into a ROTH IRA. Bugs has a tax rate of 33% so he paid $16,500 for his Roth IRA conversion. Bugs also had a bigger portfolio drop than Porky, his Roth IRA went down by 20% to $40,000. Bugs paid $3,300 too much in taxes for his Roth conversion. I would think that $3,300 has got to be too much tax by anyone’s standards.
So what should you do if you made a conversion and your portfolio tanked? First, you’ll want to make an analysis similar to Bugs and Porky’s. What’s the true cost to you in terms of taxes? Don’t forget how much it will cost to amend returns and pay your broker fees. If it makes sense to recharacterize, then by all means, do so.
Don’t get me wrong, I’m still a big fan of Roth IRAs and I still think that the Roth IRA conversion is a great tool, especially for people whose incomes are too high to make regular Roth contributions. It’s just that if recharacterizing your Roth can save you a large amount of tax money, you really should consider doing it.
Can you do a Roth conversion again later? Yes, but you’ll have to wait for at least 30 days before you do it. You’d be reporting the conversion on your 2011 return (unless you wait until 2012.) You would not get the advantage of being able to split the tax payment between two years.
I hope this sheds a little light on the situation. Remember, the deadline to recharacterize your Roth IRA to a Traditional IRA is October 17. Don’t wait until the last minute, remember that your financial adviser will need time to process the paperwork.