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How to Undo a Roth IRA Conversion

By Jason Alderman

We’ve all suffered buyer’s remorse – say you buy something you really can’t afford or the item’s sudden drop in value make it seem, in retrospect, a poor investment. That’s what has happened to some people who’ve taken advantage of IRS rules that allow them to convert a regular IRA or 401(k) into a Roth IRA, only to discover later it may not have been the right strategy.

Unlike many cases of buyer’s remorse, however, in this situation the IRS graciously allows for a do-over, called a Roth IRA “recharacterization.” Read on to learn how recharacterizations work, and whether you may be a good candidate.

First, a brief primer on IRAs. With regular IRAs you contribute pretax dollars, which lowers your current taxable income so you pay less tax now. Your account grows, tax-free, until you withdraw the money at retirement, at which point you pay income tax on withdrawals at your tax rate at the time.

By contrast, with Roth IRAs, you’re taxed on your contributions during the current year, but all withdrawals, including investment earnings, are tax-free at retirement. A few other Roth IRA features include:

  • The younger you are when you start saving in a Roth, the longer your money will compound, tax-free.
  • Unlike traditional IRAs, Roth’s have no annual required minimum distribution beginning at age 70 ½, so your account can continue to grow tax-free throughout your lifetime.
  • Heirs who inherit a Roth IRA do not pay income tax on withdrawals as they do with an inherited traditional IRA.

The IRS allows taxpayers at any income level to convert part or all of their regular IRAs or 401(k) plans to Roth IRAs. (Prior to 2010, higher-income people were excluded.) Although such conversions can provide long-term tax advantages – especially for younger people – they can be expensive in the short term, as I experienced first-hand when I did the conversion in 2010.

The cardinal rule of Roth IRA conversions is to make sure you have money outside your IRA to pay the tax bill – borrowing from your IRA will not only lessen the amount of money available to  grow tax-free, but you’ll also be subject to a 10 percent early withdrawal penalty if you’re under age 59 ½. Many online calculators can help you play with the numbers, including these from Fidelity and Vanguard.

So what about that buyer’s remorse? There are several reasons someone might want to recharacterize their converted Roth IRA:

  • You decide you can’t afford to pay the additional taxes owed after all – perhaps you become unemployed for a few months or other pressing expenses arise.
  • Adding income from the conversion puts you into a higher marginal tax bracket or subjects you to the alternative minimum tax.
  • The value of your converted Roth IRA has dropped significantly, so in effect you’re paying taxes on phantom money.

 There are a few rules to keep in mind if you decide to recharacterize:

  • You have until October 15 of the year following the conversion to recharacterize, provided you’ve filed your tax return – or filed for an extension – on time.
  • You can recharacterize all or part of the converted amount.
  • The amount you recharacterize will be adjusted for any gains or losses while it was invested in the Roth IRA.
  • To initiate a recharacterization, contact the financial institution that has your Roth IRA for instructions.
  • You’ll need to file an amended tax return (IRS Form 1040X) along with IRS Form 8606.
  • You can later reconvert the recharacterized IRA back to a Roth, but you must wait until 30 days after the recharacterization or one year after the initial conversion, whichever is later.

 A couple of strategies to consider for future IRA conversions:

  • Each year, convert only up to an amount that won’t push you into a higher tax bracket.
  • Use your conversion to open several Roth IRAs with different investment objectives or levels of risk, so if one of them tanks, you’ll only have to recharacterize that one account.
  • If you’re planning to leave your IRA to charity, it doesn’t make sense to convert to a Roth, since the charity wouldn’t have to pay taxes on donations from a regular IRA anyway.

Clearly, these are complicated transactions, so it’s probably a good idea to work with a tax professional or financial planner to guide you through the process. If you don’t have financial planner, the Financial Planning Association is a good place to search.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It’s always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney

Jason Alderman is Senior Director, Global Financial Education, with Visa, Inc.

Views expressed are the personal views of the author and do not represent the views of the National Foundation for Credit Counseling, its employees, its members, or its clients.

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